Loan Officer Training - 11/19/2024 - Analyzing Self-Employed Borrowers: Partnerships

In this episode of Loan Officer Training, we dive into the complexities of analyzing self-employed borrowers with partnerships. Understanding partnership income, tax returns, and financial structures is essential for loan officers handling these unique scenarios.

We'll break down how to evaluate K-1 forms and distributions, identify key red flags and opportunities in partnership earnings, and navigate complex financial statements with confidence.

Whether you're an experienced loan officer or just starting out, this episode will equip you with the knowledge and tools to better serve self-employed clients and close more loans. Tune in and take your lending skills to the next level!

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The Mortgage Calculator is a licensed Mortgage Lender (NMLS #2377459) that specializes in using technology to enable borrowers to access Conventional, FHA, VA, and USDA Programs, as well as over 5,000 Non-QM mortgage loan programs using alternative income documentation! 

Using The Mortgage Calculator proprietary technology, borrowers can instantly price and quote thousands of mortgage loan programs in just a few clicks. The Mortgage Calculator technology also enables borrowers to instantly complete a full loan application and upload documents to our AI powered software to get qualified in just minutes!

Our team of over 350 licensed Mortgage Loan Originators can assist our customers with Conventional, FHA, VA and USDA mortgages as well as access thousands of mortgage programs using Alternative Income Documentation such as Bank Statement Mortgages, P&L Mortgages, Asset Based Mortgage Programs, No Ratio CDFI Loan Programs, DSCR Investor Mortgages, Commercial Mortgages, Fix and Flip Mortgages and thousands more!

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Catch all the episodes of the Loan Officer Training Podcast at https://themortgagecalculator.com/Page/Loan-Officer-Training-Series-Podcast

Loan Officers for Unlimited Free Non-QM Leads & Trainings Join The Mortgage Calculator at https://themortgagecalculator.com/join

The Mortgage Calculator is a licensed Mortgage Lender (NMLS #2377459) that specializes in using technology to enable borrowers to access Conventional, FHA, VA, and USDA Programs, as well as thousands of Non-QM mortgage loan program variations using alternative income documentation!

Using The Mortgage Calculator proprietary technology, borrowers can instantly price and quote thousands of mortgage loan programs in just a few clicks. The Mortgage Calculator technology also enables borrowers to instantly complete a full loan application and upload documents to our AI powered software to get qualified in just minutes!

Our team of licensed Mortgage Loan Originators can assist our customers with Conventional, FHA, VA and USDA mortgages as well as acc...

Transcript

Restream recording Nov 19, 2024 • 05:02:31 PM: 0:13

So what exactly is a partnership? Well, a partnership is a business arrangement between two companies. Or more, uh, it is operated according to a partnership agreement. Now that partnership agreement could be an LLC, or it could be a number of documents, could be a limited partnership. There's different, uh, entities that can be used to create a partnership. Uh, very important to note that general partners have unlimited liability for the debts of the business. This is very important when you are figuring your debt to income on your self employed borrowers because the business debt will pass through to the borrowers. As it states here in the next bullet point, uh, a partnership is a pass through entity. where taxes are paid by the partners personally through their 1040 tax return. And of course, the, any liabilities are also passed through to the partners. Now, very important now here to consider then, since we've already stated that if there is a partnership and if they are self employed, that they're going to be responsible for the liabilities and taxes. And, uh, the threshold is 25 percent or greater ownership in the business. If they have a stake of 25 percent or greater ownership in the business, then they would be considered self employed and then any of the income as well as the expenses would pass through to the borrower according to their proportionate share in the business. Now, uh, regarding self employment, obviously sometimes we don't want it if it's too many expenses, but then sometimes we do want it if we need the income. So what do we do if the borrower is in business for less than two years? There are some exceptions. Now again, this is a generalized exception here. Um, you would really have to dig deep into the guidelines of the option that you're actually using. So if you're using a, um, you know, if you're going full doc or what it is exactly that you're doing here for your borrow, but please note, you know, cause if you're going non QM, you've got to look at the guidelines. If you're going agents for the guidelines for the specific program, and if you're going agency, in other words, conventional VA FHA USDA, you have to look at the selling guide. to see what it states in there and then be aware of any overlays that the investor may have. But however, generally speaking, uh, the exception for the two year rule for self employment is that the borrower is receiving the same or greater income in a similar field or position or the borrower is in a similar occupation in which they had similar responsibilities. So, you know, it's all about were they doing the same thing before. Um, A couple of examples here that I always like to add is, for example, a nurse. The nurse could have been a W 2 employee previously. Nurses have licensure, right? And now, all of a sudden, the nurse switched to 1099, right? Self employed, 1099. You know, they're a nurse. They have their license. So, typically, it's going to be as long as you have 12 months in the new position. In the new income stream, I guess we should state that would be good to still consider them self employed and be able to use the income. Another example would be an electrician. Electricians are also needing to be licensed. So they could have been working as a W 2 employee and now Get a 1099 similar scenario. It's real easy in those because you got the license to prove what they were doing is the same It's not always so cut and dry when they don't have a license, but that's where you may need additional letters of explanation including maybe from an accountant so Uh, very important here and I want to, I want you to follow the income stream here, right? Uh, the, the paper trail, so to speak. Uh, the partnership reports income on IRS form 1065. Now, uh, that's a partnership, uh, uh, report. The 1065 report, that's where the partnership reports all their income. Be aware that if it's a real estate related partnership, be on the lookout for, uh, form 8825 form. 8825 is actually the form that's used to report the, uh, profit and loss. from that particular real estate. That's where you're going to have also the depreciation that you can add back and all the other components that you could possibly add back to the income, which we're going to cover that in the next slide. But be aware IRS form 1065 and specifically inside form 1065, look for schedule 8825, which would list itemized. the income and expense for the real estate. Now the partnership reports the partnership income on form 1065 and then sends a schedule K1 to each partner to report their proportionate share of the income. So you got 1065, then we issue a K1 to our borrower for their 50 percent let's say of the income that borrower now gets that schedule k1 and reports the amount that he received in that schedule k1 in irs form 1040 the personal tax return schedule e Page two. Now, most of you know the Schedule E because that's where we report the rental income for the property, right? But that's also in page two where you report income from a partnership, from an S corp, from a C corp, you know, passive incomes or active incomes for many of those entities are reported on Schedule E, page two. So if you see a Schedule E, page two, and it has a corporation. Uh, tax ID number and the name of a corporation or the name of a partnership and it has a tax ID number and it has an amount in there, then you know that you're probably missing either the 10 65 if, if it's from a partnership. Or the 1120s if it's from an S corp or the 1120 if it's from a C corp. So be on the lookout for a 1040 Schedule E, page 2. Now, the amount that's reported on Schedule E, page 2 of the 1040 is then reported on Schedule 1 of the 1040. So, Also, if you see you have a schedule one from a 1040 that has an amount, but there's no schedule E and specifically no schedule E page one and two, then you know you're missing pages, right? The same way, if you got a schedule E with a page two and you don't have a schedule one, then you know you're missing pages. You're missing pages because sometimes borrowers send us the 1040 tax returns page by page, and they may think they don't need this page, they don't need that page, or they may not, you know, realize that they omitted a page because there's so many pages, but you know, so that's where you would have to reach back out. So again, it goes from the Schedule E page 2 to the Schedule 1, and then the amount on the Schedule 1 is then reported finally on the borrower's 1040 page 1. Line eight, right? So again, taking this in reverse. If you get a 1040 and it has an income on page one, line eight, but the borrower did not provide the schedule one and the borrower did not provide the schedule E, Pages one and two, then, you know, you're missing those pages. So please make sure you reach out to the borrower and ask them to send you the missing pages. So now, you know, it starts in IRS form 1065 and eventually works its way, the income all the way to page one line eight, which is the borrower's final proportionate share of the income. So I mentioned adding back and I'm going to get into it a little bit more here. Right? Uh,'cause these are real important key concepts. This is where when you're completing the, uh, income worksheet for the self-employed borrowers, this is where sometimes mistakes occur. So let's talk about, uh, non-cash expenses. For example, we're looking at depreciation, depletion, and amortization, right? Now, those were, uh, depreciation is pretty obvious. It's either depreciation of the real estate or depreciation of a, of a personal property asset for the business. Depletion is exhaustion of a natural resource that the business uses for its business operations. And amortization is one time business startup expenses. Now, this one is the tricky one. It has to specifically state amortization. Now, if it does not state the specific word amortization, but the accountant puts business startup expense, you may be able to get away with that one because they essentially mean the same thing, right? They're identifying it as a business startup expense because then they're probably going to write that off for the next couple of years or write off a certain amount. Now, um, one of the, uh, I, you know, an item that I wanted to add here, not on a bullet point, but very important when you're completing some of these expenses that you may see on the form is, for example, if you see property taxes or if you see, uh, interest and they're, and they report that, uh, loan on their personal credit. And that loan is going to show up on their personal credit and is going to be part and there's an REO and the schedule of real estate home for that for the end. And again, the library reports on their credit, then you would be, uh, adding back the interest. You would be adding back the taxes and you would be adding back the insurance. As long as the borrower is escrowing for taxes and insurance. So you would ask them for the mortgage statement. And if you confirm on the mortgage statement that they are asking for taxes and insurance, and this is a liability on his personal credit, then you would add those items back to the income. However, if the liability is not reporting on their credit and you're just analyzing the tax return, uh, for income, then you're not going to add back the interest. You're not going to add back the taxes and you're not going to add back the insurance. You are going to add back the depreciation. Uh, in this scenario, but you will not add back the other three items. So I just wanted to make a note there, uh, that when adding back taxes, insurance, and interest, it's only when that debt is reporting on their personal credit. And when you've confirmed for the taxes and the insurance that they're actually escrowing for that amount in the payment. So next category we have is expenses limited by the IRS. And this, uh, Section, uh, the expenses would be reduced from the income. The logic here is that since the expense is limited by the IRS, the amount that they did not write off is counted against them. So the most popular category for this is, um, meals, right? The IRS lets you deduct 50 percent of the meals from the income. So that's the case. If you get 50%. Is reduced. Uh, you know, if 50% is deducted, excuse me, as a business expense, the other 50% that is not deducted is reduced from the income because you're only deducting half of it. The logic is there's another, there's another half that's floating around there, and that half needs to be deducted from the income.'cause the IRS only let you write off. Half of it. So that's the most popular and applicable category for expenses limited by the IRS. And now the third category, which can be a little bit confusing, but this is one that I've used to my advantage to save a deal is recurring versus non recurring income and or loss. So first, what do we, what do we mean by recurring? Recurring means that it is expected to continue for at least the next three years. So if you do get a non, uh, something, uh, reported in the non recurring income, uh, category, maybe it's recurring reach out and find out what it was. Maybe it's something that you can get added as an income, but where we normally get, um, situations that arise here is when we have loss, right? We have a loss that's reported deducted from the income. It's a non recurring loss. If we can get explanation for what it is, we may be able to get it omitted as a loss because a non recurring loss is a one time event that cannot be considered towards income nor expenses, but you got to get documentation so that you can get the underwriter to omit it from the expenses as a loss. So, what would be some examples of one time events that we could get excluded? Uh, from being counted as an expense. Well, the first one would be the sale of an asset where the business is not in the sale of assets. Business like you sold a truck because you're buying a new truck, but you're not in the truck sale business. You're not a truck dealership. So you would not consider that truck sale as income. Second, second example would be a casualty loss. Casualty loss is like a fire or theft. Uh, maybe it was not covered by the insurance and you had to bear the full brunt of the loss, or maybe insurance covered only after a deductible of 5, 000 or 10, 000, for which then you had a 5, expense. Uh, those one time events, can be omitted from the expenses and can be added, added back and a paper loss carried forward is another popular example of a one time event. Uh, you could have had a loss three, four years ago, a really big loss, and then IRS rules let you write those off over a certain amount of time, a certain number of years. So that could be one where you get an explanation from the accountant as to what it was. And then, uh, hopefully get that expense added back to the income. I've been pretty successful with those. And, um, like I was saying there, the expense would need to be documented as a one time expense via letter from the accountant, if a paper loss or supporting documentation, if it is a casualty loss. Now these are, this recurring versus non recurring income or loss is one where you're, where, So, this is probably the scenario that would provide the greatest opportunity for you to recoup income and save a deal. So, um, looking to see if we have any questions. I don't give everyone an opportunity here. There has to be questions on how we calculate these incomes. Now, remember, these are all calculated using the expense, excuse me, the income calculator. The Fannie Mae income calculator is the 1084. And the Freddie Mac income calculator is the form 91. So make sure that you use the correct form for the loan type that you are processing. I'll give it another minute as I don't see any questions here. And this is a very important topic that we have. So hopefully I made it very clear on this scenario. And hopefully, uh, by the time we're done with the next week's Uh, training on this, which will be on LOCs and everybody here, uh, a self employed borrower expert income. Alright, well, no questions for today. So, uh, everybody have a good day and we will see you tomorrow. Thank you, everybody.