An Overview of Freddie Mac’s Requirements

for Self-employed Borrowers

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December 2009 2
Objectives
ƒ To help you understand Freddie Mac’s
requirements for:
Š Determining who is a self-employed borrower
Š Analyzing the different types of self-employed income
Š Documenting the income for a self-employed borrower
in the mortgage file

ƒ To provide you with tips and tools you can use to

to enhance your processes and successfully
underwrite self-employed borrowers

December 2009 3
Agenda
ƒ Self-employed borrower risk and Seller
responsibility
ƒ Freddie Mac’s definition of a self-employed
borrower
ƒ Types of businesses that need to be analyzed
ƒ Requirements for analyzing the business and
income
ƒ Mortgage file documentation requirements
ƒ Loan Prospector® data requirements
ƒ Resources
December 2009 4
Self-employed Borrower Risk
Why is more analysis
required for a self-
employed borrower?

Because a self-employed borrower is typically at

greater risk for defaulting on a loan than an
employed borrower for various reasons.

December 2009 5
Seller Responsibility for Self-employed
Borrowers

Freddie Mac looks to you to determine that

the self-employed borrower demonstrates
the financial ability to repay the mortgage.
An essential step to determine whether you
can reasonably expect the borrower to repay
the mortgage as agreed, is a careful
evaluation of the:

ƒ Borrower's income, and

ƒ Borrower’s employment history
December 2009 6
 What do you need to know?
Who is a What types
self-employed of businesses
need to be
borrower?
analyzed?

What are the

Is there
Loan Prospector
data stable monthly
requirements? income?

What Is the
documentation do business
you need in the financially
mortgage file? sound?
What’s required
for the income
analysis?

December 2009 7
 Who is a self-employed borrower?

Guide Section 37.13 (b) states…

A Borrower who has an ownership interest
of 25% or more in a business is
considered to be self-employed.

Regardless of how much the business contributes

toward their total income

December 2009 8
 Income Exercise - Mary
If Mary owns 33 percent of a small family-owned pastry
shop, but is employed full-time as an accountant and
doesn’t need the income from the family business to
qualify, do you need to analyze her tax returns?

a) Yes
b) No
Why or why not?

December 2009 9
 What are the various types of business
structures that need to be analyzed?
There are three basic business types with
variations you need to analyze:
ƒ Sole Proprietorship
ƒ Partnership (General and Limited)
ƒ Corporation
Š General
Š S-Corp
Š Limited Liability (LLC)

December 2009 10
Sole Proprietorship
Tax Returns You’ll Need
ƒ Business owned by one owner to Analyze
ƒ Easy and inexpensive to establish ƒ Form 1040, Individual Tax
Return
ƒ Income is reported on Schedule C ƒ Form 1040 Schedule C,
Profit or Loss From
of Form 1040 Business
ƒ Income is taxed at owner’s
personal tax rate
ƒ Business income is taxed at personal rate
ƒ Typically considered a more risky business classification
due to owner’s unlimited personal liability for all business
losses
ƒ Typically unable to raise large sums of money for
reinvestment
December 2009 11
General and Limited Partnerships
ƒ Business owned by two or more Tax Returns You’ll Need
to Analyze
partners
ƒ Form 1040, Individual Tax
ƒ Income reported on Form 1065 Return
(income is carried forward to Form 1040 via ƒ Form 1040 Schedule E,
Schedule K-1) Supplemental Income and
Loss
ƒ Owner’s income is reported on Part
II of Form1040 Schedule E ƒ Form 1065 Return of
Partnership Income
ƒ All income is passed through to ƒ Form 1065 Schedule K-1,
partners who pay at personal rate, Partner’s share of Income,
partnerships pay no tax Deductions, Credits, etc.

ƒ Advantages: Resources of money, skill and labor can be pooled

ƒ Difference between General and Limited Partners:
Š General partners have unlimited personal liability for all partnership debts
and losses
Š Limited partners are liable only for the amount they invested
December 2009 12
Corporation (General)
ƒ No limit to number of shareholders
ƒ Individual income is reported by
W-2’s
ƒ Corporate income is taxed at the
corporate rate
ƒ Shareholders are not personally
liable for the corporate debts
ƒ Double taxation may occur
December 2009
Tax Returns You’ll Need
to Analyze
ƒ Form 1040, Individual Tax
Return with any applicable
W-2s
ƒ Form 1120, Corporation
Income Tax Return
13
S-Corporation
ƒ Can have up to 75 shareholders
ƒ S-Corp files Form 1120S
ƒ Shareholder’s income is
reported as a distribution via K-1
on Schedule E of Form 1040
ƒ The S-Corp pays no tax on
income; all income is passed
through to its shareholders
ƒ Main advantage is no double taxation
ƒ Limited number of shareholders can make raising capital
difficult
December 2009
Tax Returns You’ll Need
to Analyze
ƒ Form 1040, Individual Tax
Return
ƒ Form 1040 Schedule E,
Supplemental Income and
Loss
ƒ Form 1120S, Income Tax
Return for an S Corporation
ƒ Form 1120S Schedule K-1,
Shareholder’s share of
Income, Deductions,
Credits, etc.
14
Limited Liability Company (LLC)
ƒ First introduced in the US in 1988 as Tax Returns You’ll Need
to Analyze
a “pass-through status”
Will depend on setup of tax
ƒ Advantages: entity; typically like a
Š Flexibility in organization and management partnership:
ƒ Form 1040, Individual Tax
Š Protection of personal assets from
Return
business debts
ƒ Form 1040 Schedule E,
Š Taxed at personal level Supplemental Income and
Š Are not restricted like S-corporations, Loss
which makes them attractive to foreign ƒ Form 1065 Return of
investors Partnership Income

ƒ Disadvantages: ƒ Form 1065 Schedule K-1,

Partner’s share of Income,
Š Limited life span Deductions, Credits, etc.
Š Each state has number of membership requirements
Š Since they are not considered a corporation, they can not have benefit of
stock ownership or sales
December 2009 15
 Business No. of Where is business Where is Taxation of
Type Owners income reported? owners' business income Main Advantage Main Disadvantage
income
reported?
Sole One Schedule C of Form Schedule C of Income is taxed at ƒ Easy and inexpensive to ƒ Unlimited personal liability for the
Proprietor 1040 (no separate Form 1040 owner's personal tax form. business and for losses.
business return) rate. ƒ Business income is taxed at ƒ Typically unable to raise large sums
personal rate. of money to invest in the business.
Partnership Two or Form 1065 (income is Part II of Partnership pays no tax ƒ Pooling of resources: money, General partners have unlimited
ƒ General more carried forward to Form Schedule E on on income; all income is labor, and skill. personal liability for partnership debts
ƒ Limited partners 1040 via Schedule K-1) Form 1040 passed through ƒ Partnership income is taxed and losses.
(via K-1 individual partners who at personal rate.
withdrawals pay tax on income at ƒ Limited partners are liable for
and personal rate. partnership debts and losses
distributions) only to the amount invested.

Corporation No limit Form 1120 Wages line of Corporate income is ƒ Shareholders are not Double taxation issue: corporate
on Form 1040 or taxed at corporate rate. personally liable for the income is taxed at corporate rate. If
number their W-2 If this income is paid to corporation's debt. income is paid to shareholders as
of share- share holders as ƒ Easy to transfer ownership dividends, this income is again taxed at
holders dividends, the share (sell shares of stock). their personal rate.
holders pay tax on it at
personal rate.

S-Corp Up to 75 Form 1120S Part II of S-corporation pays no ƒ S-corporation pays no tax on No more than 75 shareholders; limits
(Combination share- Schedule E on tax on income. All income. All income is taxed the raising of capital from a large
of partner- holders Form 1040 via income is passed at individual shareholders' number of investors.
ship & K-1 through to individual personal rate.
corporation) (distributions) share-holders who pay ƒ No double taxation.
tax on income at their
personal rate.
LLC No limit ƒ The forms necessary Part II of All income is passed Combines the limited liability Forming an LLC is more expensive
(Limited on for filing as an LLC Schedule E on through to individual protection of a corporation and than a partnership or a sole
Liability number depend on the type of Form 1040 via shareholders who pay the pass through taxation of a proprietorship. Does not offer the free
Company or of share- federal tax entity that K-1 tax on income at their sole proprietorship or transferability of owner-ship, perpetual
Corporation) holders is either elected or (distributions) personal rate. partnership. existence, and the ability to be totally
defaulted to. owned by a single individual that one
ƒ Most LLCs with more gets with a corporation. State statute
than one member file frequently limits the life span of an LLC
a partnership return, to less than 30 years. If maintained
Form 1065. beyond that, the IRS may consider it to
be a corporation.

December 2009 16
Business Types – Where’s the Greatest Risk?
ƒ A sole proprietorship is typically
considered to be more risky due
to owner’s unlimited personal
liability for all business losses
ƒ General partners also carry
personal liability for all partnership
debt and losses
ƒ A corporation is often the least risky
because the owner is not personally liable
for the company’s debt

December 2009 17
 Is there Stable Monthly Income?
Stable monthly income (qualifying income) is the borrower’s
gross monthly income from all verifiable sources that is
reasonably expected to continue for at least the next three
years. In order to consider the income stable, the borrower
must have a two-year history of receipt, in most instances.
ƒ The determination that the income is expected to continue
must be based on:
Š Occupation
Š Tenure
Š Past employment history, and
Š Probability of consistent receipt
ƒ The existence of the business must be verified by a third party
source no more than 30 days prior to the Note Date

Guide Section 37.13

December 2009 18
If Less Than a Two-year History…
ƒ Document the Borrower has a two-
year history of receipt of the income
at the same or greater level, in the
same or a similar occupation
ƒ Consider the Borrower's experience
in the business before considering
the income for qualifying purposes
ƒ Consider the acceptance of the
company’s service or products in
the marketplace
ƒ Verify Borrower's individual federal
tax returns reflect at least one year
of self-employment income
Guide Section 37.13 (b)
December 2009 19
Income Exercise – Teresa and Dan
Teresa and Dan are looking to use their combined income to
qualify for a mortgage. Dan has been employed as an
engineer in a small firm for the last six years. Teresa started
her own travel agency business 18 months ago. Before this,
she was employed as a manger in a grocery store chain. Her
business is set up as a sole proprietorship and made a small
profit her first year. Things are going well, and her second
year looks to be even more profitable than her first.
Can you use Teresa’s income to qualify?

December 2009 20
If Relocating to a Different Geographic Area…
ƒ Consider the acceptance of the company's
service or products in the marketplace before
considering the income for qualifying purposes
ƒ Document and explain how you determined that
the Borrower's income will continue at the same
level in the new location

Guide Section 37.13 (b)

December 2009 21
Is the business financially sound?
ƒ Use caution when including additional
income drawn from the Borrower's
corporation, partnership or S-corporation
as qualifying income
ƒ Analysis of the business must support
the business is clearly capable of
providing the Borrower with the
additional income used to qualify

Guide Section 37.13 (b)

December 2009 22
If using additional income from the business…
Verify:
ƒ The Borrower has legal right to
additional income. For example,
obtain a corporate resolution or
other comparable document
establishing the legal right
ƒ The Borrower’s percentage of
ownership of the business entity
from a review of the business tax
returns, letter from the accountant
for the business or similar
documents
Guide Section 37.13 (b)
December 2009 23
What are Freddie Mac’s expectation for
determining stable monthly income?
ƒ Review complete individual, and business tax
returns if applicable, to determine qualifying
monthly income
ƒ Complete a written income analysis of how you
determined the qualifying monthly income using
Form 91, or a comparable form

Guide Section 37.13 (b)

December 2009 24
Example of a Written Income Analysis Tool
ƒ Income
Analysis Form
91 available
ŠTool to help
determine self-
employed
income
ŠDoes not
replace full
analysis of the
business

December 2009 25
Example of a Written Income Analysis Tool
ƒ Instructions for
Income Analysis
Form 91
Š Provides line
item direction for
completing
analysis
Š Separate forms
should be used
for each
borrower to
complete
analysis
December 2009 26
When Analyzing the Business, Consider…
ƒ The ability to add back certain items on tax returns to
the adjusted gross income when determining
qualifying income such as:
Š Depreciation
Š Depletion
Š Amortization
Š Documented nonrecurring losses, such as casualty losses or
carry-overs from previous years
ƒ Income increases or decreases over the previous two
years – what is the income trend?
Note: If using business assets for down payment, financing costs, prepaids/escrows and
closing costs, the assets must be:
ƒ Verified in accordance with Guide Sections 37.20 - 37.23
ƒ Related to the business the borrower owns and documented in the mortgage file
Guide Section 37.13 (b)
December 2009 27
 Income Trend – Are there Significant
Increases or Decreases in Income Level?
Income

If income increases and If income decreases,

using the higher income focus analysis on the
to qualify, obtain most recent earnings
sufficient documentation and income most likely
to determine that the to be received to be
increase is stable and received at the level
likely to continue at the used for qualifying
level used for qualifying

Guide Section 37.13 (b)

December 2009 28
If You Are Not Using the Income to Qualify…
ƒ You still need to obtain the
Borrower's individual federal
tax returns to determine if
there is a business loss that
may have an impact on the
stable monthly income used
for qualifying
ƒ If a business loss is reported, you may need to
obtain additional documentation in order to fully
evaluate the impact of a business loss on the
income used for qualifying, so you can make a
determination about the borrower’s financial ability
to repay the mortgage
Guide Section 37.13 (b)
December 2009 29
What documentation do you need in the mortgage file?
ƒ Tax returns for the two most recent years*
ƒ Signed 8821, 4506 or 4506-T
ƒ Verification of existence of the business from a
third party source no more than 30 days prior to
the Note Date
ƒ Income Analysis on Form 91, or similar form
ƒ Written Analysis of your conclusion on Form 1077,
or another document
*Unless Loan Prospector returns a Streamlined Accept documentation level
requiring one year of tax returns and you can otherwise document a two-year
history of income
Note: In lieu of tax returns, Form 8821, 4506 or 4506-T from the IRS is acceptable, provided all line items
are obtained
Guide Section 37.13 (b), 37.22 and 37.23
December 2009 30
Written Analysis Requirement
Must include written
analysis of the income used
to qualify the borrower in the
mortgage file.

“An income analysis of Mr. B’s last two tax

returns show an average monthly income of
$3,000 from his consulting business. Mr. B
has been in the same line of work for the past
ten years and self-employed for the last four
years. Analysis of the business reflects stable
growth for the last two years that’s projected
to continue into the foreseeable future.
Assets are strong, with little debt. The
business appears financially sound overall,
and ….”

For example:
1077 Underwriting Comments Section

December 2009 31
Loan Prospector Documentation Matrix
www.FreddieMac.com/learn/pdfs/uw/docmatrix.pdf

December 2009 32
Income Exercise - Marion
Marion has owned his own landscape business for the
last 5 years. The business operates as a sole
proprietorship. According to his tax returns, Marion's
income, after adding back noncash expenses, was
$28,000 last year and $32,000 for the previous year.

1. Would you consider this to be an example of stable

monthly income?
2. How would you determine monthly income?

December 2009 33
What are Loan Prospector’s data requirements?
1. Indicate self-employed for each borrower who has 25% or more
ownership in a business, regardless if the income is used to qualify
2. Enter the total amount of self-employed income used for qualifying*
3. Include the amount of self-employed income in the total monthly
income*

3. 1.

2.

*If using the Monthly Income Breakdown, enter the amount of self-employed income in an
appropriate field so Loan Prospector automatically includes the self-employed income in the
Monthly Income total
December 2009 34
 Loan Prospector example
Shawn manages a sporting goods store earning $4,500 per month. For the last several
years, he’s owned a small tree trimming business. His tax returns from the previous two
years indicate this business has been providing him with an average of $1,000 of additional
income per month. How would you enter Shawn’s employment information in Loan
Prospector if:
1. Using Shawn’s income from the tree trimming business to qualify?
2. You determined the tree trimming business income wasn’t stable enough to use?

1.

2.

December 2009 35
Recap – Reminders for Responsible Lending
1. Determine your borrower’s ownership interest in the
business(es)
2. If 25% or more ownership interest, indicate self-employment in
Loan Prospector or manually underwrite as self-employed
3. Obtain the documentation required by Loan Prospector’s
documentation level, or the Guide if manually underwriting
4. Analyze the documentation to ensure financial stability exists
(additional documentation may be required if unable to
determine stability with minimum documentation
5. Obtain signed IRS Form 8821/4506/4506-T
6. Provide a written summary on your analysis of the business on
Form 1077 or similar and include your income analysis showing
how the income was calculated
December 2009 36
Additional Resources
ƒ Freddie Mac’s Single-Family Seller/Servicer
Guide Chapter 37
ƒ Your Freddie Mac Representative
ƒ 1-800-FREDDIE
ƒ www.IRS.gov/
ƒ Mortgage Insurance Company resources

December 2009 37
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December 2009 38
 Questions?

Please complete post-session survey that appears to the right of this slide

December 2009 39
 Thank you for your participation!

Notice
This document is not a replacement or substitute for the
requirements set forth in the Freddie Mac Single-Family
Seller/Servicer Guide (Guide) and/or terms of your Master
Agreement and/or Master Commitment.

December 2009 40