Self-Employed Income, Declining Profits, and a Large Gift
Two weeks before closing, a loan officer reviews a sole proprietor’s file. The 2022 Schedule C shows net profit of $104,000, depreciation of $18,000, and business use of home of $4,800. The 2023 Schedule C shows net profit of $92,000, depreciation of $18,000, and business use of home of $4,800. The borrower wants a $405,000 purchase loan with 10% down. The proposed PITI is $3,050. Monthly consumer debt is $720: $420 car and $300 student loan. Credit score is 680. After closing, the borrower will have $8,000 in reserves. The borrower has $20,000 of own funds and a $25,000 gift from an aunt. The lender’s DTI limit is 45%. The borrower says, “Use the 2022 number because it is higher, and don’t count the home-office deduction-it’s not real cash.”
1. Calculate the borrower’s qualifying income and DTI under two reasonable approaches, and explain which approach is more defensible.
Read the worked answer
Start by adding back non-cash or personal-housing deductions: depreciation and business use of home. For 2022: $104,000 + $18,000 + $4,800 = $126,800. For 2023: $92,000 + $18,000 + $4,800 = $114,800. The 2023 figure is lower, so using the lower year produces monthly qualifying income of $114,800 ÷ 12 = $9,566.67. Total monthly debt is $3,050 + $720 = $3,770. DTI is $3,770 ÷ $9,566.67 = 39.4%. Using the two-year average produces $120,800 ÷ 12 = $10,066.67 and a DTI of 37.4%. Both are below the 45% limit, but the declining profit trend makes the lower-year approach more defensible. A 9.5% decline from 2022 to 2023 should be explained, and the loan officer should document why the trend is not expected to continue. Simply choosing the higher year because it helps qualification is not acceptable.
2. The borrower argues that the home-office deduction should not be counted because “it’s not real cash.” How should the loan officer respond?
Read the worked answer
The borrower has the logic backwards. The home-office deduction reduced the business’s net profit on the tax return, but it did not represent a cash payment to an unrelated third party in the same way as, for example, advertising expense. Adding it back is generally appropriate because it is a non-cash or personal-housing expense that was deducted from business income. Depreciation is also added back because it is a non-cash deduction. The loan officer should not allow the borrower to pick and choose add-backs to maximize income. The tax returns should be analyzed consistently, and the loan officer should follow the lender’s written income-analysis guidelines. If the home-office deduction is tied to a separate structure or creates a cash expense that should not be added back, the lender’s underwriter should make that determination and document it.
3. Can the $25,000 gift be used, and what documentation and reserve concerns remain?
Read the worked answer
A gift from an aunt can generally be used for down payment and closing costs if the program allows gifts, but it must be documented. The file needs a signed gift letter stating the donor’s relationship, the amount, and that no repayment is expected. It also needs evidence of the donor’s ability to give the funds and evidence of transfer into the borrower’s account or to the closing agent. The loan officer should verify whether the program requires a minimum borrower contribution. The borrower has $20,000 of own funds against a $450,000 purchase price, which is about 4.4%. If the program requires 5% from the borrower’s own funds, the borrower is short by about $2,500. Reserves are $8,000, or 2.6 months of PITI. That may satisfy a two-month reserve requirement but not a six-month requirement. The loan officer should confirm the exact program guidelines rather than assume the gift solves every issue.