Self-Employed Income, K-1 Distributions, and a Target DTI
Married borrowers apply for a $420,000 conventional purchase. Borrower A earns $8,400 per month as a W-2 employee. Borrower B is a 25% owner of an S-corporation and also runs a consulting business on Schedule C. The 2023 and 2024 returns show Schedule C net profit of $54,000 and $57,000. The 2024 figure includes $18,000 of depreciation, $4,800 of business-use-of-home, and a $12,000 gain on the sale of a used piece of equipment; 2023 depreciation was $15,000. The K-1 shows $30,000 of ordinary income and $45,000 of cash distributions, and the S-corporation pays $1,200 per month to lease a vehicle titled in Borrower B's name. New PITI is $3,150; monthly debts are $420 auto, $160 student loan, and $200 minimum credit card. Borrower B started the consulting business in November 2023. The originator wants to count the $45,000 of distributions and the equipment gain to 'get comfortable' with a higher DTI.
1. Calculate Borrower B's qualifying monthly income and the total DTI, explaining each inclusion and exclusion.
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Schedule C. 2024: $54,000 + $18,000 depreciation + $4,800 business-use-of-home − $12,000 nonrecurring equipment gain = $64,800. 2023: $54,000 + $15,000 depreciation = $69,000. The 2024 figure is lower, a decline. Lenders typically average when income is stable or rising but use the most recent year when it has declined materially; $64,800, or $5,400 per month, is the defensible number.
S-corporation. 25% × $30,000 ordinary income = $7,500, or $625 per month. The $45,000 of distributions is cash already reflected in the K-1 income and must not be added again - that is the double count the originator is proposing.
Vehicle lease. Do not add it to income. Verify who is obligated; if the borrower is personally liable, count $1,200 as a debt.
Total. $8,400 + $5,400 + $625 = $14,425 per month. Debts = $420 + $160 + $200 + $3,150 = $3,930. DTI = 27.2%, nowhere near 49%.
2. Does the file support an ability-to-repay determination, and does the November 2023 start date create a problem?
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Start with the ATR factors, not the target DTI. The creditor must consider and verify income, assets, debts, employment, and the monthly payment. Income here is verifiable through two years of returns plus a year-to-date P&L, and a DTI of roughly 27% is well below the old 43% threshold, so the loan is likely a General QM unless the APR exceeds the APOR threshold (2.25 percentage points for a first lien) or the product has prohibited features.
The self-employment history is the soft spot. The business began in November 2023, so 2023 is a partial year. Standard guidance calls for two years of self-employment; less is acceptable only with documented training or experience in the field. Get underwriting's written analysis before issuing a preapproval.
Do not move the borrower to a stated-income or bank-statement product to dodge the issue without a documented reason and the required disclosures. The correct path is a documented income analysis, not a workaround.
3. What documentation should the originator collect before the file goes to underwriting?
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Collect: complete federal returns for 2023 and 2024 with all schedules and K-1s; the S-corporation's returns and K-1s; a year-to-date profit-and-loss statement and balance sheet through the most recent month; business license; a CPA letter confirming the equipment sale was a one-time disposition and whether any depreciation was recaptured; documentation of the home-office deduction; vehicle title and lease showing the obligor; W-2s and pay stubs for Borrower A; recent statements for all asset accounts; credit reports for both borrowers if both apply; and a written explanation of the declining 2024 income.
Also confirm the borrowers' intent on the application and that all debts - including the card minimum and the vehicle lease if personally obligated - appear on the 1003. Compensating factors such as reserves, low DTI, and credit depth should be documented but cannot substitute for verified income. The originator's job is to present the file accurately, not to reach a target DTI.