Self-Employed Income, Declining Trend, and a Business Debt
A self-employed borrower owns 100% of an S corporation and applies for a $380,000 purchase loan. He takes a $60,000 W-2 salary each year. The 2023 S-corp return shows ordinary business income of $48,000, depreciation of $15,000, and a $6,000 deduction for business use of home. The 2024 return shows ordinary income of $32,000, depreciation of $15,000, and the same $6,000 home-office deduction. The corporation has a $25,000 equipment loan; the monthly payment is $550 and the loan is in the business name. The borrower's personal debts are a $650 car payment and a $300 student loan. Proposed housing payment including taxes and insurance is $2,450. The lender's overlay caps DTI at 45% and requires a two-year average of self-employed income, but allows a declining trend to be considered. The loan officer wants to add back the home-office deduction and use the 2023 income because it produces a higher DTI.
1. Calculate the borrower's qualifying self-employed income for 2023 and 2024, explaining each add-back and deduction.
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Start with W-2 salary plus S-corp ordinary income. Add back depreciation because it is a non-cash expense. Do not add back the home-office deduction absent evidence that it is non-cash or non-recurring; it is a recurring business expense and the lender's policy allows only documented non-cash add-backs. Subtract the business equipment loan payment because the borrower owns 100% of the corporation and the business pays the debt, reducing cash available to the owner. For 2023: $60,000 + $48,000 + $15,000 − $6,600 = $116,400. For 2024: $60,000 + $32,000 + $15,000 − $6,600 = $100,400. The two-year average is $108,400. The loan officer's proposed add-back of the $6,000 home-office deduction would increase income, but it is not supported by the lender's policy or by the nature of the expense.
2. What monthly income and DTI result from the average and from the declining 2024 year, and does the loan meet the 45% overlay?
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Using the two-year average of $108,400, monthly qualifying income is $108,400 ÷ 12 = $9,033. Total monthly debts are $2,450 housing + $650 car + $300 student = $3,400. DTI is $3,400 ÷ $9,033 = 37.6%. Using the 2024 income of $100,400, monthly income is $8,367, and DTI is $3,400 ÷ $8,367 = 40.6%. Both are below the 45% overlay, so the loan can meet the lender's DTI limit even with the declining trend. However, the loan officer should not use 2023 alone, which would produce an artificially low DTI. The declining trend justifies using the lower year or at least documenting why the average is representative. Taxes, insurance, HOA dues, and any other obligations must be included before final approval.
3. How should the loan originator document and present the income analysis, and what should happen if the borrower cannot explain the 2024 decline?
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The loan originator should prepare a written income analysis showing the W-2, S-corp ordinary income, depreciation add-back, business debt deduction, and the two-year average, along with a narrative explaining the 2024 decline. The borrower should provide a year-to-date profit-and-loss statement, business bank statements, and a letter explaining the decline-for example, lost customers, higher materials costs, or a one-time expense. If the decline is unexplained or appears likely to continue, the lender should use the lower 2024 income or decline the loan rather than averaging upward. The loan originator must not add back the home-office deduction simply to raise income. If the file is borderline, legitimate options include reducing the loan amount, paying off the car or student loan, adding an eligible co-borrower, or documenting compensating factors under the lender's policy.