Introduction
When a person has an ownership stake in a partnership or a certain type of company called a Limited Liability Company (LLC), they must report their share of the business’s income or losses on their personal tax returns. This is done using specific tax forms provided by the IRS: Form 1065 for the business and Schedule E on their personal Form 1040. If you want to dive deeper into the structures of partnerships and LLCs, you can look up section B3-3.2-02 in the guidelines.
Evaluating the Business Income
If someone owns 25% or more of a business, the lender looking into their mortgage application needs to carefully check the business’s finances. This includes looking at the cash flow, which is a measure of the money coming in and going out of the business. The lender is checking to see if the business’s income is steady and if it has been making more money over time. If the business doesn’t show stable and increasing income, then the person’s earnings from the business might not be considered reliable for paying back a mortgage.
Borrower’s Proportionate Share of Income or Loss
How much money someone can claim from the business depends on their share of the business’s ending capital for the year, as shown on a special part of Form 1065 called Schedule K-1. However, lenders won’t just take this figure and use it. They first need to adjust it based on a detailed look at the business’s cash flow to ensure it reflects true, available income.
Adjustments to Business Cash Flow
When analyzing a business’s cash flow, certain items can be added back because they don’t actually reduce the cash available for the owner to use. These include things like depreciation, which is an accounting way to spread out the cost of big purchases over several years, and one-time losses from events like natural disasters.
However, some things need to be subtracted from the business cash flow, such as:
– Money spent on travel and meals that isn’t fully allowed.
– Any income that doesn’t regularly happen and won’t likely continue.
– The total due within the next year for long-term debts unless the business has a line of credit or clear evidence it can continually cover these debts without issue.
Income from Partnerships, LLCs, Estates, and Trusts
For income from a partnership, LLC, estate, or trust to be considered, the lender needs proof of two things. One, the income shown on Schedule K-1 was actually given to the person. Or two, the business has enough liquid money (easily accessible funds) to allow the person to take out their earnings without hurting the business.
Lenders have some freedom in how they confirm the business can afford to pay out earnings. They might look at the business’s tax returns and use a common formula to see if the business has enough current assets (things easily turned into cash) compared to its current debts. There are two main formulas they might use:
– The Quick Ratio (or Acid Test Ratio), which is good for businesses that have a lot of inventory. It calculates if the business can cover its immediate debts without selling off its stock.
Quick Ratio = (current assets – inventory) / current liabilities
– The Current Ratio (or Working Capital Ratio), which is better for businesses that don’t rely on inventory. It checks if the business has enough current assets to cover its current debts.
Current Ratio = current assets / current liabilities
A result of one or more in these tests usually means the business has enough liquid assets. However, lenders can use other ways to show the business is financially healthy, as long as they explain their reasoning.
References
For more details, visit Analyzing Partnership Returns for a Partnership or LLC of the Fannie Mae Selling Guide.