Background

The U.S. workforce has shifted: more Americans earn income outside traditional W‑2 paychecks. Lenders responded by widening acceptable documentation and using averaging or alternative verification to measure a borrower’s earning capacity. This evolution matters because underwriting focuses on the likelihood that a borrower can repay over time—not just a single month of high receipts (CFPB).

How lenders verify income (step‑by‑step)

  1. Tax returns and tax transcripts
  • Lenders commonly request 2 years of Form 1040s and accompanying schedules (especially Schedule C for sole proprietors). They use these to confirm reported gross receipts, net profit, and business expenses. Many lenders may also pull IRS tax transcripts for verification (IRS).
  1. Bank statements and cash‑flow review
  • Bank statements show deposit patterns and cash flow. For workers paid in cash or via third‑party apps, lenders may average monthly deposits over 12–24 months to establish sustainable income. Some programs (bank‑statement loans) let borrowers substitute multiple months of statements for tax returns; see practical documentation tips in our bank‑statement loan guide Bank‑statement loans for the self‑employed.
  1. Contracts, invoices, and receivables
  • Ongoing client contracts, recurring invoices, and letters of engagement help underwriters project future income. Lenders favor multi‑month or multi‑year agreements that demonstrate continuity.
  1. Profit & Loss statements and accountant letters
  • A year‑to‑date profit & loss (P&L) statement—preferably prepared by accounting software or an accountant—helps bridge gaps between tax filings and current performance. An accountant’s letter that verifies income methodology can strengthen an application.
  1. Alternative/automated verification
  • Automated income verification services can pull IRS transcripts or connect to bank data to speed underwriting. While convenient, borrowers should confirm which services a lender accepts and whether they require explicit consent (IRS; CFPB).

How lenders assess stability

  • Averaging: For variable income, lenders frequently average income over 24 months or use a weighted average (most recent year may carry more weight).
  • Adjustments: Lenders commonly add back non‑cash expenses (depreciation) and may subtract one‑time gains. The result is an adjusted net income used for debt‑to‑income (DTI) ratios.
  • Seasonality: Seasonal income is annualized and averaged; documentation that shows recurring seasonality (e.g., tax returns over several years) helps.

Real‑world examples

  • Example 1: A freelance web designer presented two years of Schedule C returns, six months of bank statements, and three active client contracts. The lender averaged the net income from Schedule C, added back depreciation, and used bank statements to confirm cash flow—result: mortgage preapproval.
  • Example 2: A rideshare driver lacking recent tax returns used 24 months of bank deposits and a year‑to‑date profit & loss. The borrower qualified under a bank‑statement program after the underwriter confirmed consistent monthly deposits.

Who is affected / eligible

Nontraditional workers who commonly use these methods include:

  • Freelancers and gig workers (rideshare, delivery, independent contractors)
  • Consultants and 1099 contractors
  • Small‑business owners and sole proprietors

Preparation checklist (professional strategies)

  • Keep 2+ years of filed tax returns and Schedule C/K‑1s where applicable.
  • Maintain 12–24 months of business and personal bank statements.
  • Produce a current, software‑generated P&L and balance snapshot.
  • Gather client contracts, invoices, or recurring payment histories.
  • Consider an accountant’s letter explaining any large write‑offs or irregularities.
  • Talk to lenders early about which income programs they offer (e.g., bank‑statement loans, automated verification). See our guide on non‑standard documentation for more detail: Non‑standard income documentation for self‑employed borrowers.

Common mistakes and misconceptions

  • Mistake: Believing one lender’s rules apply to all. Documentation and underwriting tolerances vary widely. Shop multiple lenders and ask about specific programs.
  • Mistake: Using tax‑minimizing strategies without realizing the underwriting impact. Large legitimate deductions lower reported net income on Schedule C and can reduce qualifying income unless you can document add‑backs.
  • Myth: Nontraditional workers are automatically denied. Many lenders have programs designed for variable income—preparation matters.

Frequently asked questions

Q: Can I use projected or contract income?
A: Lenders sometimes accept projected income when backed by signed contracts or letters of intent, but they typically require historical documentation to rely on projections.

Q: What if I can’t produce 2 years of tax returns?
A: Alternatives include bank‑statement programs, YTD P&L with supporting deposits, or lender‑specific exceptions. Expect stricter scrutiny and possible higher rates.

Q: Will an automated IRS transcript speed approval?
A: Yes—automated verification can speed underwriting, but the lender must accept that service and you must authorize the data pull (IRS).

Relevant reading

Practical note from my experience

In my practice advising self‑employed clients, the single most effective step is organization: a clean packet with 2 years of returns, a current P&L, recent bank statements, and any recurring contracts removes ambiguity and cuts underwriting time.

Professional disclaimer

This article is educational and does not replace personalized financial or legal advice. Rules and program availability change; check with your lender and tax advisor for guidance tailored to your situation.

Authoritative sources

(Information current as of 2025.)