SALARIES, WAGES, AND OTHER FORMS OF EFFECTIVE INCOME:

  The income of each borrower to be obligated for the mortgage debt must be analyzed to determine whether it can reasonably be expected to continue through at least the first three years of the mortgage loan.  If the borrower intends to retire during this period, the effective income must be the amount of documented retirement benefits, social security payments, or other payments expected to be received in retirement.  No inquiry may be made regarding possible future maternity leave.

In most cases, the borrower’s income will be limited to salaries or wages.  Income from other sources can be included as effective income with proper verification by the lender.  Procedures for analyzing other acceptable income sources besides salaries and wages are described below:

Overtime and Bonus Income-  Both overtime and bonus income may be used to qualify if the borrower has received such income for the past two years and it is likely to continue.  The lender must develop an average of bonus or overtime income for the past two years, and the employment verification must not state that such income is unlikely to continue.  Periods of less than two years may be acceptable provided the lender justifies and documents in writing the reason for using the income for qualifying purposes.

An earnings trend also must be established and documented for overtime and bonus income.  If either type shows a continual decline, the lender must provide a sound rationalization in writing for including the income for borrower qualifying.  If bonus income varies significantly from year to year, a period of more than two years must be used in calculating the average income.

Part-Time Income-  Part-time/second job income, including employment in seasonal work, may be used in qualifying if the lender documents that the borrower has worked the part-time job uninterrupted for the past two years and will continue to do so.  Seasonal employment (e.g., umpiring baseball games in summer, working at a department store during the holiday shopping season) is considered uninterrupted and may be used in qualifying if the lender documents that the borrower has worked the same type of job for the past two years and expects to be rehired during the next season.  Income from a part-time position that has been received for less than two years may be included as effective income, provided the lender justifies and documents that the income's continuance is likely.  Income from part-time positions not meeting these requirements may be considered as a compensating factor only.

For qualification purposes, part-time income refers to jobs taken to supplement the borrower's income from regular employment (i.e., a second job – not meaning primary jobs of less than 40 hours per week.)  If a borrower's regular employment involves less than a typical 40-hour workweek, the stability of that income should be evaluated as any other regular, on-going primary employment.  For example, a registered nurse may have worked 24 hours per week for the last year.  Although this job requires less than 40 hours of work per week, it is the borrower's primary employment and is to be considered effective income.

We recognize that many low- and moderate-income families rely on part-time and seasonal income for day-to-day needs.  Lenders must not restrict the consideration of such income sources in qualifying these borrowers.

Military Income- In addition to base pay, military personnel may be entitled to additional forms of pay.  Income from variable housing allowances, clothing allowances, flight or hazard pay, rations, and proficiency pay is acceptable, provided its probability of continuance is verified in writing.  An additional consideration may be the tax-exempt nature of some of these payments (see paragraph Q for additional information.)

Commission Income- Commission income must be averaged over the previous two years.  The borrower must provide copies of signed tax returns for the last two years, along with the most recent pay stub.  (Unreimbursed business expenses must be subtracted from gross income.) Individuals whose commission income shows a decrease from one year to the next require significant compensating factors to allow for loan approval.  Borrowers with commission income received for more than one but less than two years may be considered favorably provided the underwriter is able to make a sound rationalization for acceptance and can document the likelihood of continuance.

Commissions earned for less than one year are not considered effective income.  Exceptions may be made for situations in which the borrower's compensation was changed from a salary to commission within a similar position with the same employer.  A borrower also may qualify when the portion of earnings not attributed to commissions would be sufficient to qualify the borrower for the mortgage.

Retirement and Social Security Income-  Retirement and social security income require verification from the source (former employer, Social Security Administration) or federal tax returns.  If any benefits expire within the first full three years, the income source may be considered only as a compensating factor.

Alimony, Child Support, or Maintenance Income-  Income in this category may be considered as effective if such payments are likely to be consistently received for the first three years of the mortgage.  The borrower must provide a copy of the final divorce decree, legal separation agreement, or voluntary payment agreement, as well as evidence that payments have been received during the last twelve months.  Acceptable evidence of payment regularity includes cancelled checks, deposit slips, tax returns, and court records.  Periods less than twelve months may be acceptable, provided the payer’s ability and willingness to make timely payments is adequately documented by the lender.

Notes Receivable.  A copy of the note must be presented to establish the amount and length of payment.  The borrower also must provide evidence that these payments have been received consistently for the last twelve months, which may include deposit slips, cancelled checks, or tax returns.  If the borrower is not the original payee on the note, the lender must also establish that the borrower is now a holder in due course and able to enforce the note.

Interest and Dividends- Interest and dividend income may be used, provided that documentation (tax returns or account statements) supports a two-year history of receipt.  This income must be averaged over the two years.  Any funds derived from these sources and required for the cash investment must be subtracted before the projected interest or dividend income is calculated.

Mortgage Credit Certificates-  If a government entity subsidizes the mortgage payments, either through direct payments or through tax rebates, these payments can be considered as acceptable income if verified in writing.  Either type of subsidy may be added to gross income or may be used to directly offset the mortgage payment before calculating the qualifying ratios.

Employer Differential Payments-  If the employer subsidizes the mortgage payments through direct payments, the amount of the payments is considered gross income; it may not be used to offset the mortgage payment directly, even if the employer pays the servicing lender directly.

VA Benefits-  Direct compensation, such as for a service-related disability, is acceptable, subject to documentation from the VA.  Education benefits, used to offset education expenses, are not acceptable.

Government Assistance Programs- Income received from government assistance programs is acceptable, subject to documentation from the paying agency, provided the income is expected to continue at least three years.  If the income is not expected to be received for at least three years, such income may be considered as a compensating factor.  (Unemployment income must be documented for two years.  Reasonable assurance of its continuance is also required.  This requirement may apply to individuals employed on a seasonal basis, such as farm workers, resort employees, etc.)

Rental Income-  Rent received for properties owned by the borrower is acceptable if the lender can document that the rental income is stable.  Examples of stability may include a current lease, an agreement to lease, or a rental history over the previous 24 months that is free of unexplained gaps greater than three months.  (Student, seasonal, or military renters, or property rehabilitation would provide such an explanation).  A separate schedule of real estate is not required for rental properties, provided all properties are shown on the URLA.

If the borrower resides in one or more units of a multiple-unit property and charges rent to tenants of other units, that rent may be used for qualifying purposes.  However, projected rent of additional units only and not the owner-occupied unit(s) may be considered gross income only after deducting the HOC’s vacancy and maintenance factor.  They may not be used as a direct offset to the mortgage payments. 

Income from roommates in a single-family property to be occupied as the borrower's primary residence is not acceptable.  Rental income from boarders is acceptable if the boarders are related by blood, marriage, or law.  The rental income may be considered effective income if shown on the borrower's tax returns.  Otherwise, the income only may be considered a compensating factor and must be documented adequately by the lender.

THE FOLLOWING IS REQUIRED TO VERIFY ALL RENTAL INCOME:

1. Schedule E of IRS Form 1040.  Depreciation may be added back to the net income or loss shown on Schedule E.  Positive rental income is considered gross income for qualifying purposes; negative rental income must be treated as a recurring liability.  The lender must be certain that the borrower still owns each property listed, by comparing the Schedule E with the real estate owned section of the residential loan application.  (If the borrower in the same general area owns six or more units, a map disclosing the locations must be submitted evidencing compliance with FHA's seven-unit limitation.  See paragraph 4-8 for additional information.)

2. Current Leases.  If a property was acquired since the last income tax filing and is not shown on Schedule E, a current signed lease or other rental agreement must be provided.  The gross rental amount must be reduced for vacancies and maintenance by 25 percent (or the percentage developed by the jurisdictional HOC), before subtracting PITI and any homeowners' association dues, etc., and applying the remainder to income (or recurring debts, if negative).

N. Eligible Investment Properties.  If the property to be insured is an eligible investment property or sold through FHA's REO program, the following calculations of qualifying ratios apply:

1. Subtract the monthly payment (PITI) from the monthly net rental income of the subject property (gross rents, minus the 25 percent reduction or HOC’s percentage reduction for vacancies and repairs).  If this calculation yields a positive number, add the number to the borrower's monthly gross income.  If the calculation results in a negative number, consider it a recurring monthly obligation; then
2. Calculate the mortgage payment-to-income ratio (top or front-end ratio) by dividing the borrower's current housing expense (principal residence) by the monthly gross income.  (The monthly gross income will include any positive cash flow from the subject investment property.); and
3. Calculate the total fixed payment-to-income ratio (bottom or back-end ratio) by dividing the borrower's total monthly obligations, including any net loss from the subject investment property, by the borrower's total monthly gross income.

O. Automobile Allowances and Expense Account Payments.  Only the amount by which the borrower's automobile allowance or expense account payments exceed actual expenditures may be considered income.  The borrower must provide IRS Form 2106, Employee Business Expenses, for the previous two years to establish the amount of income that may be added to gross income.  The borrower also must provide verification from the employer that these payments will continue.  (If these calculations show a loss, that amount must be treated as a recurring debt.  If the borrower uses the standard per-mile rate in calculating automobile expenses, as opposed to the actual cost method, the portion that the IRS considers depreciation may be added back to income.)  Additionally, the borrower's monthly car payment must be treated as a recurring debt; it may not be offset by the car allowance.

P. Trust Income.  Income from trusts may be used if guaranteed, constant payments will continue for at least the first three years of the mortgage term.  Documentation is required and includes a copy of the Trust Agreement, or other trustee's statement, confirming amount, frequency of distribution, and duration of payments.  Funds from the trust account also may be used for the required cash investment with adequate documentation.

Q. Non-Taxable Income.  If a particular source of regular income is not subject to federal taxes (e.g., certain types of disability and public assistance payments, military allowances), the amount of continuing tax savings attributable to the non-taxable income source may be added to the borrower's gross income.  The percentage of income that may be added may not exceed the appropriate tax rate for that income amount, and no additional allowances for dependents are acceptable.  The lender must document and support the adjustments (the amount the income is "grossed up") made for any non-taxable income source.  Child support income cannot be grossed up.  The lender should use the tax rate used to calculate last year's income tax for the borrower.  If the borrower is not required to file a federal income tax return, the tax rate to use is 25 percent. 

R. Projected Income.  Projected or hypothetical income is not acceptable for qualifying purposes.  However, exceptions are permitted to this rule for income from cost-of-living adjustments, performance raises, bonuses, etc., which are both verified by the employer in writing and scheduled to begin within 60 days of loan closing.

If a borrower is about to start a new job and has a guaranteed, non-revocable contract for employment that will begin within 60 days of loan closing, the income is acceptable for qualifying purposes.  The lender also must verify that the borrower will have sufficient income or cash reserves to support the mortgage payments and any other obligations during the interim between loan closing and the start of employment.  (This condition may be appropriate for situations such as teachers whose contracts will begin with the new school year, or physicians who will begin residency after the loan is scheduled to close.)  However, if the loan will close more than 60 days before the borrower’s employment begins, the loan is not eligible for endorsement until the lender provides a pay stub or other acceptable evidence that the borrower has begun the new job.

2-8 EMPLOYMENT BY FAMILY-OWNED BUSINESSES.  Borrowers employed at businesses owned by their family member(s) are required to provide additional income documentation.  These borrowers must provide the normal verification of employment, pay stubs, and evidence that they are not an owner of the business.  This evidence may include copies of the borrower's signed personal tax returns or a signed copy of the corporate tax return showing ownership percentages.

2-9 SELF-EMPLOYED BORROWERS.  A borrower with a 25 percent or greater ownership interest in a business is considered self-employed for FHA mortgage loan underwriting purposes.

The following conditions apply to underwriting self-employed borrowers:

A. Minimum Length of Self-Employment.  Income from self-employment is considered stable and effective if the borrower has been self-employed for two or more years.  The high probability of failure during the first few years of a business makes the following requirements necessary for individuals who have been self-employed less than two years:

1. Between One and Two Years.  An individual self-employed between one and two years must have at least two years of documented previous successful employment (or a combination of one year of employment and formal education or training) in the line of work in which the borrower is self-employed or in a related occupation to be eligible.

2. Less than One Year.  The income from a borrower self-employed less than one year may not be considered effective income.

B. Documentation Requirements.  The following documents are required from self-employed borrowers:

1. Signed and dated individual tax returns, plus all applicable schedules, for the most recent two years.

2. Signed copies of federal business income tax returns for the last two years, with all applicable schedules, if the business is a corporation, an "S" corporation, or a partnership.

3. A year-to-date profit-and-loss (P&L) statement and balance sheet.

4. A business credit report on corporations and "S" corporations.

C. Analyzing Income.  The lender must establish the borrower's earnings trend over the previous two years but may average the income over three years, if all three years' tax returns are provided.  If the borrower provides quarterly tax returns, the analysis can include income through the period covered by the tax filings.  If the borrower is not subject to quarterly tax filings or does not file quarterly returns (Form IRS 1040 ES), the income shown on the P&L statement may be included in the analysis, provided the income stream based on the P&L statement is consistent with the previous years' earnings.  If the P&L statements submitted for the current year show an income stream considerably greater than what is supported by the previous years' tax returns, the analysis of income must be predicated solely on the income verified through the tax returns.

To determine if the business can be expected to continue to generate sufficient income for the borrower's needs, lenders must analyze carefully the business's financial strength, the source of its income, and the general economic outlook for similar businesses in the area.  Annual earnings that are stable or increasing are acceptable.  Conversely, a borrower whose business shows a significant decline in income over the period analyzed is not acceptable, even if current income and debt ratios meet our guidelines.

There are four basic types of business structures: sole proprietorships, corporations; limited liability ("S" corporations); and partnerships.  Each type requires slightly different forms of analysis.

The following provides additional information on analyzing tax returns:

1. Individual Tax Returns (IRS Form 1040).  The amount shown on the IRS Form 1040 as "adjusted gross income" either must be increased or decreased, based on the lender's analysis of the individual tax returns and any related tax schedules.  Particular attention must be paid to the following:

a. Wages, Salaries, and Tips.  An amount shown under this heading may indicate that the individual is a salaried employee of a corporation or has other sources of income.  It also may indicate that the spouse is employed, in which case the income must be subtracted from the adjusted gross income in the analysis.

b. Business Income or Loss (from Schedule C).  The sole proprietorship income calculated on Schedule C is business income.  Depreciation or depletion may be added back to adjusted gross income.

c. Rents, Royalties, Partnerships, Etc. (from Schedule E).  Any income received from rental properties or royalties may be used as income after adding back any depreciation shown on Schedule E.

d. Capital Gain or Loss (from Schedule D).  This transaction generally occurs only one time, and it should not be considered in determining effective income.  However, if the business has a constant turnover of assets resulting in gains or losses, the capital gain or loss may be considered in determining the income, provided the borrower has at least three years' tax returns evidencing capital gains.  An example includes an individual who purchases old houses, remodels them, and sells them for a profit.

e. Interest and Dividend Income (from Schedule B).  This income, which is taxable and tax-exempt, may be added back to the adjusted gross income only if it has been received for the past two years and is expected to continue.  (If the interest-bearing asset will be liquidated as a source of the cash investment, the lender must adjust accordingly.)

f. Farm Income or Loss (from Schedule F).  Any depreciation shown on Schedule F may be added back to the adjusted gross income.

g. IRA Distributions, Pensions, Annuities, and Social Security Benefits.  The non-taxable portion of these items may be added back to the adjusted gross income, if the income is expected to continue for the first three years of the mortgage.

h. Adjustments to Income.  Certain adjustments to income shown on the IRS Form 1040 may be added back to the adjusted gross income.  Among these adjustments are IRA and Keogh retirement deductions, penalties on early withdrawal of savings, health insurance deductions, and alimony payments.

i. Employee Business Expenses.  These expenses are actual cash expenses that must be deducted from the borrower's adjusted gross income.

Corporate Tax Returns (IRS Form 1120).  Corporations are state-chartered businesses owned by their stockholders.  Compensation to its officers, generally in proportion to the percentage of ownership, is shown on the corporate tax returns and will appear on individual tax returns.  If the borrower's percentage of ownership is not shown, it must be obtained separately from the corporation's accountant, with evidence that the borrower has the right to those funds.  Once the adjusted business income is determined, it should be multiplied by the borrower's percentage of ownership in the business.

In analyzing the corporate tax returns, lenders must adjust for the following:

a. Depreciation and Depletion.  The corporation's depreciation and depletion must be added back to after-tax income.

b. Taxable Income.  Taxable income is the corporation's net income before federal taxes.  It must be reduced by the tax liability.

c. Fiscal Year vs. Calendar Year.  If the corporation operates on a fiscal year that is different from the calendar year, an adjustment must be made by the lender to relate corporate income to the individual tax return.

d. Cash Withdrawals.  The borrower's withdrawal of cash from the corporation may have a severe negative impact on the corporation's ability to continue operating.

"S" Corporation Tax Returns.  An "S" corporation is generally a small, start-up business, with gains and losses passed on to stockholders in proportion to each stockholder's percentage of business ownership.  The income for the owners comes from W-2 wages and is taxed at the individual rate.

The "compensation of officers" line on the IRS Form 1120S is transferred to the borrower's IRS Form 1040.  Both depreciation and depletion may be added back to income in proportion to the borrower's share of income.  However, income also must be deducted proportionately by the total obligations payable by the corporation in less than one year.  The borrower's withdrawal of cash from the corporation may have a severe negative impact on the corporation's ability to continue operating and must be considered in the analysis.

Partnership Tax Returns.  A partnership is formed when two or more individuals form a business and share in profits, losses, and responsibility for running the company.  Each partner pays taxes on his or her proportionate share of the partnership’s net income.

Both general and limited partnerships report income on the IRS Form 1065; this form must be reviewed by the lender to assess the viability of the business.  The partner's share of income is carried over to Schedule E of IRS Form 1040.  Both depreciation and depletion may be added back to income in proportion to the borrower's share of income.  However, income also must be deducted proportionately by the total obligations payable by the partnership in less than one year.  The borrower's withdrawal of cash from the partnership may have a severe negative impact on the partnership's ability to continue operating and must be considered in the analysis.

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