How Underwriters Average Tax Returns for a Self-Employed Mortgage

The Quick Read: Underwriters take the net income shown on your traditional personal-income documentation, add back deductions that did not cost you cash, average the result over two years, and divide by 24 to get one monthly qualifying income figure; when income is falling, many use the lower year instead of the average. That is the standard full-documentation method, and it is an industry habit more than a single universal formula.

• The starting point is net income after business expenses, never gross revenue or deposits.
• Non-cash deductions such as depreciation are usually added back. Cash expenses are not.
• Rising or flat income is typically averaged. Falling income often defaults to the lower year.
• Bank statement and DSCR programs skip tax-return averaging, but each has its own tests.

If you run a business or own rentals, you probably write off a lot on purpose. This guide shows exactly how those write-offs turn into a coverage figure, and what to do when the number comes out too low.

What Does Averaging Mean to an Underwriter?

Averaging means the underwriter blends your last two years of adjusted net income into one steady monthly figure. The goal is to avoid qualifying you on one unusually good year or hiding a weak one. Lenders want income that looks repeatable.

A salaried borrower shows up with a pay stub. A self-employed borrower shows up with a tax return, and a tax return is built to minimize taxable profit. So the underwriter reads the return backward, starting from the profit line, restoring costs that never left your bank account, and then looking at the trend.

Averaging is the most common approach on full-documentation loans, but each lender writes its own rules. The mechanics below are typical, not guaranteed, and they vary by program.

Key Terms Defined

Qualifying income: The single monthly income figure the lender uses to decide how much you can borrow.

Net income: Business revenue minus business expenses and deductions. On a sole proprietor’s return, this is the net profit line from Schedule C.

Add-back: A deduction the underwriter puts back into your income because no cash actually left the business.

K-1: The form that reports an owner’s share of income from a partnership or S corporation.

DTI (debt-to-income ratio): Your monthly debts divided by your monthly income. Lower is better.

Expense factor: A percentage a bank statement lender subtracts from deposits to estimate business costs. It stands in for tax-return expenses.

How the Calculation Works, Step by Step

Here is the typical sequence on a full-documentation file. Individual lenders vary on details.

1. Collect the documents. Expect two years of personal returns with all schedules, two years of business returns if you own an entity, and a year-to-date profit-and-loss statement. Business bank statements are sometimes added. NerdWallet notes that lenders generally treat you as self-employed if you own 25% or more of a business, work as a 1099 contractor, or file a Schedule C.

2. Start from net income. Sole proprietors start at the Schedule C net profit. Partners and S-corporation owners start from K-1 income and the business return.

3. Add back non-cash items. Depreciation, depletion and amortization are the classic add-backs. Business use of home is often added back too.

4. Remove one-time items. A one-off gain that will not repeat usually comes out of the number.

5. Compare the years. Underwriters look at direction. Rising or stable income is averaged, while falling income often uses the lower figure.

6. Divide by 24. Add the two adjusted years and divide by 24 to get monthly income.

7. Cross-check. The underwriter compares the profit-and-loss statement and bank statements against the returns. Big mismatches trigger more questions and sometimes a smaller number.

The monthly figure then becomes the income side of your DTI. That ratio decides how much house the file can support.

Which Add-Backs Count?

Most underwriters accept add-backs for costs that reduced your tax bill without reducing your cash. Treatment still varies by lender.

Section 179 is where files get surprised. It lets a business deduct equipment costs up front, and on partnership or S-corporation returns it flows through the K-1. Many lenders will not add it back at all, so ask before you buy equipment and file.

Agency-style files also run the return through a standardized cash-flow worksheet. DSCR loans are not agency products, so that worksheet only matters if you take a full-documentation route.

Three Worked Examples

These examples use units, not dollars, so you can see the logic.

Take the rising case first. Year two earned 50% more than year one, yet the average sits at 125 against a current run rate of 150. You are being qualified on roughly 83% of what you earn today.

Flip the order and the picture changes. If income fell from 150 to 100, the average would be 125, but a cautious underwriter may use 100. That is 20% below the average and 33% below the earlier peak.

In the third case, income is flat at 100 each year, but depreciation of 20 units per year is added back. Qualifying income lands at 120 per year. Add-backs can move the number as much as trend does.

The divide-by-24 step is a practitioner convention. A lender may weight the years differently, and some programs allow a year-to-date profit-and-loss statement to support a rising trend.

Where the Starting Number Comes From by Business Type

Each business structure feeds the worksheet from a different place.

Ownership percentage matters. Owners of 25% or more are typically asked for the business return, not only the personal one. Distributions you actually took and income that passes through to you can differ, and underwriters often look at whether the business has the liquidity to keep paying you.

Where the Two-Year Habit Came From

The two-year convention is older than most borrowers realize. The CFPB’s Appendix Q treated self-employment income as stable once a borrower had two or more years in the business. It asked for two years of signed returns and a year-to-date profit-and-loss statement. It also said a current-year profit-and-loss statement could not override what the prior returns supported.

Appendix Q has since been removed. The Congressional Research Service summarizes that the CFPB dropped it after originators found it unclear and complex. Lenders now build their own documentation rules, so the two-year average survives as a habit and a risk-control choice, not a statute.

That is also why the rules differ between lenders. One may let a strong year-to-date report lift a rising average. Another may not.

Where the Averaging Rule Breaks

The average works until your file does something unusual. These are the common breakpoints.

Declining income. Even a temporary drop invites scrutiny. Underwriters usually want a written explanation and a current profit-and-loss statement, and many fall back to the lower year.

Rising income. Averaging understates your current earnings, as the first example showed. A year-to-date report helps on some programs and not on others.

Less than two years in business. Some programs make a one-year exception when you worked in the same field as an employee before going out on your own. Others ask for a larger down payment or a co-borrower.

Mixed W-2 and business income. The salary side follows normal rules. The business side follows the self-employed rules, often with two years of returns.

Rental income. Income from your rentals can count, but it is documented separately with leases or schedules, not folded into business income.

Mismatched documents. If deposits do not reasonably track the returns, expect extra conditions. An unresolved gap can make the income unusable.

What Your Deductions Do to Your Number

Every dollar of cash expense you deduct lowers taxable income, and it lowers qualifying income by the same amount. That is the tension at the center of self-employed borrowing: tax strategy and mortgage strategy pull in opposite directions.

Investors feel this twice. Depreciation on your own rentals is a standard add-back, which helps. But passive losses and other write-offs can still shrink the averaged figure, and a full-documentation loan pulls every property’s debt into your personal DTI at the same time. Your averaged income lags your real earnings, while your debts are fully current.

Timing matters. Talk to your loan officer before your accountant files, because once a return is filed you generally live with it. Tax treatment can depend on how the funds are used and how the property is held; borrowers should keep clear records and speak with a qualified tax professional before relying on any deduction.

Three Ways to Document a Rental Purchase

When the averaged number is too low, you have other paths. They are different tests, not shortcuts.

Bank statement loans. Instead of traditional personal-income documentation, these programs read your deposits. Qualifying income comes from deposit averages after a lender-specific expense factor, so write-offs matter far less. The loan is reviewed on documented income under the applicable program, subject to lender guidelines. Across the wholesale network, loan sizes run roughly $125,000 to $3,500,000, and reserves commonly sit around six months of the housing payment.

Leverage depends on the transaction and the occupancy:

• Primary residence, purchase or rate-and-term refinance: up to 90% LTV through select lenders, with stronger files earning the top of the range.
• Primary residence, cash-out: up to 80% LTV with a fixed expense ratio, or 75% with an accountant-prepared ratio.
• Second home, cash-out: up to 75% LTV, depending on loan size and credit.
• Investment property, cash-out: tops out around 75% LTV.
• Investment property, purchase: varies by lender, so treat it as a lender-by-lender question.
• Asset depletion alternative: qualifying from liquid assets runs to about 80% LTV on a primary residence.

Occupancy also decides the paperwork. An owner-occupied bank statement loan is a consumer mortgage, so TRID disclosures apply. A bank statement loan on a non-owner-occupied rental, including a short-term rental, is business-purpose and exempt from TRID.

DSCR loans. DSCR means debt service coverage ratio. These loans are designed for non-owner-occupied investment properties and qualify primarily on property-level rental income covering the payment, subject to lender guidelines. There is no personal income averaging, because the lender is not asking what you earn. Lenders still review credit, assets, an appraisal, and rent evidence, usually an appraiser’s rent schedule or a lease. Some select lenders in the network offer programs below 1.00 coverage, but leverage and terms adjust when they do. Lendmire’s piece Is There a Self-Employed Mortgage That Skips Tax Returns? walks through the options, and the complete DSCR loans guide covers the investor side in depth.

For a borrower with big write-offs and a rental that clearly covers itself, DSCR sidesteps the averaging problem. For a borrower with strong net returns and no property yet, full documentation may be a more affordable path. Honestly, most self-employed investors weigh all three before choosing.

Common Mistakes

Assuming gross revenue counts. On tax-return loans, underwriters use net income after expenses. Deposits matter only in bank statement programs, where an expense factor is applied.

Expecting the best year to win. A strong current year rarely overrides weaker prior returns on full-documentation files. Practice varies by lender.

Treating every write-off alike. Non-cash items are usually restored. Cash expenses are not.

Believing non-QM means no documentation. Alternative programs still verify repayment ability. The documents change, but the verification does not.

Calling DSCR a no-paperwork loan. It involves no personal income documentation, yet it still looks at credit, reserves, appraisal, and rent evidence.

Filing first and asking later. Planning the return around the loan, before it is filed, is the one fix that costs nothing.

Next Steps

If you are self-employed and want to see how the numbers work, Lendmire can help you compare bank statement loan options based on your deposits, the property, credit profile, leverage, and your goals. Owner-occupied bank statement lending is available in a 16-state footprint, and all programs are subject to lender guidelines and underwriting review. For a clearer picture of how full documentation compares, read Lendmire’s guide on how many years of tax returns a self-employed mortgage needs.

A two-year average is only a snapshot, and the investors who borrow best treat their last two tax filings as part of the loan plan.

For current guidelines and terms, see Lendmire’s self-employed mortgage programs page.

About Lendmire

Lendmire (NMLS# 2371349) is a mortgage brokerage serving self-employed and high-net-worth borrowers in 16 states. Bank statement, P&L-only, 1099-only and asset-based mortgages are arranged through wholesale lending channels; Lendmire brokers the financing and the lender underwrites each application. Scotsman Guide named Lendmire a Top Mortgage Workplace in both 2025 and 2026.

References

1. NerdWallet, Requirements for Self-Employed Mortgage Borrowers

2. CFPB Appendix Q to Regulation Z

3. Congressional Research Service, The Ability-to-Repay Rule