The Declining K-1: Building Income You Can Defend
Priya owns 100% of a consulting S-corp. Her 2024 K-1 shows $62,000 of ordinary business income, down from $85,000 in 2023, and the business return shows gross receipts down 18%. Her CPA writes that revenue "should level off" but provides no projections or supporting analysis. Priya also receives $18,000 a year of non-taxable Social Security disability income and owns a rental condo that grosses $1,400 per month against a $910 PITI. She is buying a $340,000 primary residence with 10% down on a 30-year fixed at 7.00%. Estimated PITI on the new home is $2,350 including taxes and insurance. Her only other debt is a $620 car payment. Middle FICO is 742 and she has two months of reserves.
1. Build the qualifying income figure. What do you use for the K-1 income, the Social Security, and the rental income, and why?
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K-1 income: $62,000 / 12 = $5,166.67.
Because Priya owns 100% of the S-corp she is self-employed; the K-1 ordinary income flows to her, but it is not automatically qualifying income. Two years of returns are in file and the trend is down (receipts -18%), so agency guidance (Fannie Mae B3-3.1-01 and -03) directs the most recent year alone unless the decline is documented as not continuing. A CPA sentence saying revenue "should level off" is a conclusion, not documentation.
I would also:
- Confirm the ordinary income was actually available to Priya (business liquidity/deposits support the K-1).
- Strip out any non-recurring items in the 2024 return.
- Keep the 2024 return in file and current.
Social Security: $1,500/mo x 1.25 = $1,875.
Documented non-taxable income may be grossed up by 25% because it is not subject to federal tax; $18,000/12 = $1,500.
Rental: $1,050 - $910 = $140 net.
Agency guidance uses 75% of gross rents when the borrower does not document actual expenses, less the PITI on that property. If Schedule E documents lower actual expenses, use the lower net figure.
Total qualifying income = $5,166.67 + $1,875 + $140 = $7,181.67/month.
2. Compute the total debt-to-income ratio and state whether it is defensible.
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Obligations: $620 car + $2,350 proposed PITI = $2,970/month.
DTI: $2,970 / $7,181.67 = 41.35%.
Is that defensible? Yes, with the file as documented:
- 41.35% is inside most conventional program limits, but you should not describe it as "safely under the 43% QM cap." Since the 2021 amendments, the General QM definition is price-based, the 43% hard DTI cap and Appendix Q are gone. That does not relax the Ability-to-Repay rule (12 CFR 1026.43(c)): the ratio still has to reflect a reasonable, good-faith determination that Priya can repay.
- Investor overlays commonly cap at 45% or 50%; a 41% ratio with a 742 score and two months of reserves is within typical tolerances.
- Sensitivity: the file only works because her income is not the two-year average. If the 2025 YTD numbers confirm receipts down further, this file goes away and I would say so before the borrower pays for an appraisal.
3. The processor proposes averaging 2023 and 2024 to bring the DTI down to about 36%. How do you respond?
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Averaging here is reverse-engineering the ratio, not underwriting it.
- Averaging ($73,500/12 = $6,125, total income about $8,140, DTI about 36.5%) produces a rosier number than the evidence supports. Two years of declining receipts plus no documentation of stabilization means the most recent year governs unless the decline is documented as temporary and non-recurring.
- Choosing the method that makes the deal work, rather than the method the evidence supports, is the practice that gets files repurchased and originators disciplined, and it can support a UDAAP claim against the lender.
Legitimate ways to help Priya:
- Get a 2025 year-to-date P&L plus business and personal bank statements and a CPA letter that ties to specific signed contracts, not an opinion.
- Add a co-borrower.
- Reduce the loan amount (larger down payment) to bring the ratio down.
- Restructure the rental income with Schedule E support if actual expenses are lower than the 75% allowance.
If none of those work, the honest answer is that the file does not qualify at this loan amount today.