K-1 income: how lenders read partnership pay

This post walks through how a lender reads K-1 income under the conventional loan rules in the Fannie Mae Selling Guide. It covers which K-1 you get, the difference between your share and your cash, the business cash test, and the documents a lender asks for. It does not say whether a given file will be approved, and it is not tax or legal advice. FHA, VA, and other loan programs have their own rules, and a lender can add its own requirements on top, so ask early. For the wider self-employed document list, see how self-employed borrowers document income for a mortgage.

Which K-1 you get depends on how the business files

A K-1 is the form a business uses to report each owner's share of its income or loss. The guide spells out which version applies. A partnership reports on Form 1065, Schedule K-1. An S corporation reports on Form 1120S, Schedule K-1. An LLC can land on either one, depending on how it files its federal return. Source: Selling Guide B3-3.6-07, Income or Loss Reported on Schedule K-1

That matters because the lender reads the business return that sits behind your K-1, and the two returns are analyzed differently. If you are not sure how your LLC files, your tax preparer can tell you in one sentence. Our post on the documents you send for a sole prop, LLC, or S-corp covers the rest of that split.

Your share is not the same as your cash

The K-1 shows your share of the business's profit for the year. It does not show how much of that profit the business actually paid out to you. A business can earn money on paper and keep it in the company account to buy equipment, pay down debt, or hold as a cushion.

The guide tells lenders to use caution here. Ordinary income and net rental income on a K-1 can count toward your income, but only if the lender can confirm the business has enough cash to let you take that money out. There are two ways a file usually gets there.

A steady distribution history. If your K-1 shows a documented, stable history of cash distributions that line up with the income the lender is using, the rule says no further proof of access or business cash is needed.

A business cash check. If the distributions are missing, uneven, or lower than the income being used, the lender has to confirm the business has adequate liquidity instead.

So two owners with the same K-1 profit can get different results. One took the money out every year. The other left it in the business, and now the lender has to look at the company's balance sheet before it can count that income.

How a lender checks business cash

The guide leaves the method up to the lender but gives two common formulas, both built from the business return:

• The current ratio compares current assets to current liabilities. It fits businesses that do not depend on inventory, such as a consulting firm or a medical practice.
• The quick ratio, also called the acid test, takes inventory out of current assets first. It fits businesses that depend heavily on inventory, such as a retail shop.

The guide says a result of one or greater is generally enough to show the business can support the withdrawal. In plain terms, the business should have at least as much in short-term assets as it owes in short-term bills. A lender can also support liquidity another way if it documents why. Source: Selling Guide B3-3.7-01, Analyzing Partnership Returns

If you know your business carries a lot of short-term debt at year end, mention it to your lender early. It is easier to talk through before the file reaches an underwriter.

Guaranteed payments count on their own track

Some partnerships and LLCs pay a partner a set amount for their work, no matter how the year turns out. These show up on the K-1 as guaranteed payments to the partner. The rule says that if you have a two-year history of receiving them, they can be added to your income.

The guide also notes that an owner may get wages or other pay from the business on top of the K-1 share. If you are paid both ways, give your lender both sets of paperwork so nothing gets counted twice or left out.

How much of the business you own changes the review

Ownership size decides how deep the lender digs.

Under a quarter of the business. The guide has a separate set of rules for owners with less than a quarter of a partnership, S corporation, or LLC. The lender collects your two most recent years of signed personal federal returns and K-1s and does a verbal check of your employment. It needs a two-year history of the income. It does not have to analyze whether the business itself is viable, and it may use only your share of earnings from the K-1. The distribution or business cash test above still applies. Source: Selling Guide B3-3.4-19, Schedule K-1 Income

That same section has a narrow exception for professional practices. If you recently bought a small ownership stake in a firm such as a medical practice or law firm after working there for a while, the lender may rely on your guaranteed pay without the two-year history. Your partnership agreement and year-to-date income have to back it up.

A quarter or more. At that level you are treated as self-employed. When business returns are required, the lender does a cash flow analysis of the business and checks that income is stable and that sales and earnings trends are positive. If the business does not meet those standards, the rule says its income cannot be used to qualify you. Our post on declining self-employed income covers what happens when the trend points down.

What the lender adds back and takes out

For owners who get the full cash flow review, the partnership section of the guide lists adjustments. Depreciation, depletion, amortization, casualty losses, and other losses that are not consistent and recurring can be added back. The travel and meals exclusion, one-time income, and business debts due in under a year are subtracted. That last one is not required for lines of credit, or when the debt rolls over regularly or the business has enough liquid assets to cover it.

Your share is then based on your percentage of ending capital as shown on your K-1. If your ownership changed during the year, check that the K-1 reflects it. For more on how write-offs shape the number a lender uses, see how business write-offs affect mortgage qualifying income.

Documents to gather

• Your most recent one or two years of signed personal federal returns, with every K-1 attached. The lender tells you which.
• The business's federal returns, Form 1065 or Form 1120S, for the most recent two years, or one year if the file meets the guide's requirements. Some files can skip business returns entirely if they meet the waiver rules.
• Records of the distributions you took, if your K-1 does not show them clearly.
• Your partnership or operating agreement, especially if you get guaranteed payments or recently became an owner.
• A year-to-date profit and loss statement if the lender asks. Our post on when a lender asks for a year-to-date P&L explains that request.

Questions to ask a lender

• Will you need my business returns, or only my personal returns and K-1s?
• My K-1 profit is higher than what I took out. How will you handle the difference?
• Which business cash test will you use for my type of business?
• Do you add any requirements for K-1 income beyond the standard guide?

FAQ

Does a lender count all the income on my K-1?

Not automatically. The lender has to confirm the money was distributed to you at about the level being used, or that the business has enough cash to let you take it. Without one of those, the income generally cannot be counted.

What if I own only a small piece of the business?

Owners with less than a quarter of the business follow a shorter set of rules. The lender still needs two years of personal returns and K-1s and still checks distributions or business cash, but it usually does not review the business as a whole.

Are guaranteed payments treated differently?

Yes. With a two-year history, guaranteed payments to a partner can be added to your income on their own, apart from your share of the profit.

One thing to do

Disclaimer: Jeff Shin, Mortgage Loan Originator, NMLS #1041652. Chicago. Equal Housing Lender. Not a commitment to lend.

Sources: Fannie Mae Selling Guide B3-3.6-07, Income or Loss Reported on IRS Form 1065 or IRS Form 1120S, Schedule K-1; B3-3.7-01, Analyzing Partnership Returns for a Partnership or LLC; B3-3.4-19, Schedule K-1 Income for owners of less than a quarter of the business.