Self-Employment Qualifying Income: Partnerships Made Simple
How Your K-1 and 1065 Tax Returns Affect Mortgage Approval
If you own a partnership, determining which income counts towards a mortgage can be confusing. In this article, I’ll walk you through how mortgage underwriters determine qualifying income from partnerships. I’ll show you how to use your K-1 and the partnership’s 1065 tax return, with a practical example, so you can see exactly how it works.
Before we get into it, I want to tell you a couple of things clearly:
Calculating qualifying income for self-employed borrowers is unique to each individual. These articles give you an idea of the process. You don’t need to figure it out yourself; your lender will handle the math.
This article is for informational purposes. I want you to be prepared for what your lender will need and WHY. That is always the primary goal of my work here at Underwriting Truths for Homebuyers. I want to help you navigate the homebuying mortgage process by providing information that will make it less daunting.
What’s a Partnership (Refresher)
A partnership is a business owned by two or more people. The business files Form 1065, and each partner’s share of profits or losses is reported on a Schedule K-1. That K-1 flows to your personal tax return, usually on Schedule E.
Most partners don’t get a regular paycheck; they take distributions instead, and each partner pays taxes individually on their share of the income.
Step 1: Start with Your K-1
The K-1 shows your actual share of the partnership’s income and losses. These figures are already calculated according to your ownership percentage. Mortgage underwriters use these numbers to start to determine qualifying income for your mortgage.
Items on your K-1 commonly used for qualifying income include:
Guaranteed payments you received
Ordinary business income or loss
Net rental income or loss
These figures do not get adjusted. Distributions aren’t automatically counted; they only count if they are regular and recurring. Your lender will determine this for you based on the loan type you are requesting and the stability of these earnings.
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Step 2: Review the 1065
Next, underwriters review the partnership’s 1065 tax return. Some deductions reduce taxable income on paper but don’t reflect actual cash leaving the business. These are called “add-backs” or “paper losses”. The most common add-back is depreciation. Other possible add-backs are amortization and depletion. They are not as common as depreciation, but common enough to mention.
Other items, like meals and entertainment deductions, reduce cash flow and are always subtracted. The IRS allows businesses to claim a portion of these actual expenses to reduce taxable income. However, since these expenses are actual, underwriters must deduct them from your qualifying income.
Ownership percentage matters. Any add-back or subtraction from the 1065 is multiplied by your ownership percentage from the K-1. K-1 numbers themselves are never adjusted.
Step 3: Quick Math Example
Let’s look at a simple example.
Partner ownership: 50%
Calculations for 2024:
From K-1: Guaranteed payments: $8,000
From K-1: Ordinary business income: $30,000
From 1065 (Line 16c): Depreciation add-back: $5,000 × 50% = $2,500
From 1065 (Schedule M1, Line 4b): Meals & entertainment subtraction: $1,000 × 50% = $500
Total 2024 qualifying income = $38,000 + $2,500 - $500 = $40,000
Calculations for 2023:
From K-1: Guaranteed payments: $7,500
From K-1: Ordinary business income: $28,000
From 1065 (Line 16c): Depreciation add-back: $4,000 × 50% = $2,000
From 1065 (Schedule M1, Line 4b): Meals & entertainment subtraction: $900 × 50% = $450
Total 2023 qualifying income = $35,500 + $2,000 - $450 = $37,050
Step 4: Average Two Years
Underwriters usually look at two years of tax returns to see consistent income. Here, we average the 2024 and 2023 qualifying income:
Average qualifying income = ($40,000 + $37,050) ÷ 2 = $38,525 or $3,210 per month.
Notice how the 2024 income is higher than the 2023 income. That’s a good sign; it shows the business is growing, which underwriters (and business owners) like to see.
What if the income is declining:
The underwriter will want an explanation letter.
The underwriter may have to use only the lower year instead of averaging.
If it is determined that the business income is not stable, the income may not be used as qualifying income.
Remember, that’s why explanation letters matter. If your income drops, explain why. The underwriter is not your enemy here. They’re trying to understand your business, and a clear letter helps them do that.
Step 5: Year-to-Date P&L and Balance Sheet
To confirm your business is still on track, underwriters usually require a year-to-date profit & loss statement (P&L). This shows the company is still generating income at a similar level and confirms stability. If it is not, you will need to explain why.
If your income is seasonal, for instance, if most of your money comes in the fall, you can explain that. Underwriters don’t know your business cycles unless you tell them, and a brief explanation can clarify things.
Some loan types may require a balance sheet, along with the YTD P&L. The balance sheet shows the business’s assets and liabilities, helping the lender understand financial stability. Your lender will know if you need to provide this.
Key Takeaways for Homebuyers
K-1 numbers are final. They already reflect your ownership percentage and flow to your 1040.
1065 adjustments are prorated. Add-backs and subtractions, like depreciation and meals/entertainment, are multiplied by your ownership percentage as shown on the K-1.
Two-year average matters. Declining income can affect how much you can use for qualifying.
Provide all documents. Personal tax returns, partnership tax returns, YTD P&L, and possibly a balance sheet. Missing pages and schedules slow down the mortgage process.
Cash flow drives qualification. Underwriters focus on what’s actually available, not just taxable income.
Help Your Lender Help You
As I mentioned earlier, all of this might sound overwhelming, but remember this: underwriters are not looking for reasons to say no. They want you to qualify. Their job is to ensure the income used for approval is accurate and reliable, meeting each loan type’s specific requirements.
The best way you can help is by being clear about your business. If you had a one-time expense, a slow season, or costs that suddenly jumped, explain it. Most of the time, there is a reasonable story behind the numbers, and an explanation can make a big difference.
