Income Averaging for Self-Employed Borrowers: When Fannie Mae Allows It and When It Does Not

Calculating self-employed income correctly is one of the highest-stakes tasks in residential underwriting. Fannie Mae allows averaging in some scenarios and prohibits it in others. Using the wrong method either overstates qualifying income (a compliance risk) or kills a deal that should close.

The 24-Month Average Rule

When self-employment income is stable or increasing year-over-year, Fannie Mae allows the underwriter to average the two most recent tax years. If Year 2 is higher than Year 1, the average of both years is the qualifying income. The business must have been in existence for at least two years; a two-year-old business with only one year of returns does not satisfy the requirement even if the borrower was previously employed in the same field.

Declining Income Scenarios

• ✦If Year 2 income is lower than Year 1, the underwriter must use Year 2 only, not the average of both years
• ✦If the declining trend exceeds roughly 25% year-over-year, additional analysis is required to assess whether income is stable enough to qualify
• ✦A year-to-date P&L is required when there is a significant income decline or when the underwriter needs to assess current-period trends
• ✦If YTD income annualized is lower than Year 2, some investors require using the YTD annualized figure

One-Year Tax Return Exception

Fannie Mae's Selling Guide permits the use of one year of self-employment tax returns under specific conditions: the borrower must have been self-employed in the same line of work for at least two years immediately prior to the application, and the most recent year return must reflect the same or greater income than prior W-2 or employment income. This is not a default option; the underwriter must document prior employment in the same field and that income is stable. Lender overlays frequently require two years regardless of agency eligibility.