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What Self-Employed Borrowers Need to Know About Distribution Income

To qualify for a mortgage, you will need to provide a wide variety of information, including documents related to your income.

However, the income you can use for qualification goes beyond the typical weekly paycheck. Lenders will also consider financial accounts, retirement funds, trust funds, and other sources of regular income. If you are involved in a business partnership or S-corporation, the lender can also consider information listed on your K-1 document, which is a tax form used to confirm amounts that are passed from a business organization to an individual.

This money is known as “distribution income,” and while the path to using this funding for qualification may seem complex, using the funds is actually simple and can increase the amount you could borrow. In the end, this could mean a larger, higher-quality home for you and your family.

What is Distribution Income?

To fully understand this topic, we need to take a closer look at the concept of distribution income. This is essentially an owner’s withdrawal from a business, and it’s based on the profit the business generates. Business owners can leave the funding in the business accounts, or they can withdraw it for personal use, such as paying for a mortgage or general living expenses. Regardless of the business structure, this distribution to owners may or may not appear in the profit and loss statement.

Using Distribution Income and the K-1 Form for Mortgage Qualification

In 2015, Fannie Mae reexamined the process of mortgage qualification for potential borrowers who receive a K1 income. For many years, Fannie Mae and Freddie Mac required lenders to confirm that the income used in qualification from the Schedule K Form was supported by the cash distributions of a business. Before the changes, many lenders were simply not aware of the process behind distribution of income, or they would simply ignore it and use K1 income with little to no further thought.

Fortunately, this topic is better understood by lenders, creating new opportunities for borrowers. However, there remains some confusion on the process when it comes to meeting the guidelines of using K-1 lines 1, 2, and 3, as well as the Cash Flow Analysis section.

To help you better understand the process, let’s look at a few examples of how the income reporting can be utilized by the borrower, allowing them to get you qualified for a larger loan…

Fannie Mae B3-3-2.1-08
This section of the guidelines deals with income or loss that is reported on the IRS form 1065 and 1120S K-1. It essentially states that if the K-1 shows a stable, sustained history of cash distributions, then no further documentation will be required.

Borrowers can utilize this guideline through the help of their lender. The lender will need to follow the steps and pay attention to the various options that Fannie Mae allows to use the income properly. First, the lender will need to confirm the business has stable earnings and then they will need to complete a cash-flow analysis. They will complete the 1084 form and determine that the income you are attempting to use does come from the K-1. They will then compare this to the amount of distributions that you receive.

You and the lender will now see one of three situations…

Situation 1: When Distributions are More Than the Total Qualifying Income

Modern home with pool and lounge chair
Using distribution income could help you purchase the home of your dreams.

The first option is to use a 1065 of 1120S Business Form. With this option, you will add up lines 1, 2, and 3, as well as the Cash Flow Adjustments to reach your total qualifying income. You can then use this sum to qualify and nothing further is needed.

Situation 2: Distributions are Less Than the Total Qualifying Income

If the distributions are less than the total qualifying income, the distributions total can be used instead of the qualifying income amount. This does not necessarily mean you are using the distributions to qualify, it simply means that the business cannot support the business income to qualify, but it can support the smaller amount.

Important Note: For both options, it’s essential that you remember that distributions are only being used in the support of the qualifying income. Essentially, you are using whichever number is smaller to qualify.

Situation 3: No Distributions

If you have a K-1 income but your K-1 shows no distributions or the distribution level is too low to qualify, the lender can use your business’s liquidity. In this situation, the lender will essentially determine if the business has the funds but chooses not to pay out distributions. If this is the case, the lender will use the same lines in the K-1 form. However, if the business does not have the funds to pay distribution, the lender will be unable to use the lines.

The lender will use the Schedule L for both 1065 and 1120S forms. Fannie Mae provides a formula in their guidelines that will test the business’s capital. 

Distribution Income Becoming an Important Part of the Real Estate Industry

Before 2016, Freddie Mac did not have any written guidelines regarding checking into a business’s distributions of income. Essentially, the only time you need any added review is when the lender needs to used income outside of what is stated on Form 91.

However, there have been guidelines updates in 2017. These guidelines use the same rules and terms as Fannie Mae. This is a long section of guidelines, but the information will lineup with the guidelines provided by Fannie Mae.

This topic was neglected by institutions and lenders for years, but it is now an important part of the real estate and lending industries. If you are self-employed, you must understand the details of this system so you can make the appropriate choices for your next mortgage loan. 

Providing Expert Guidance for Your Mortgage Qualification

If you want help understanding the use of distribution income, contact the helpful team at San Diego Purchase Loans.

We’ll show you the details of using these income factors for mortgage qualification, allowing you to purchase the top-quality home you deserve!