Income averaging as it relates to filing federal income tax forms for those old enough to remember, was a way for earners to average their income over a few years to lower the taxable income.  The way it worked happened when someone received a rather large, taxable check for something like a bonus orbanks average income other large non-regular income.

Say a guy was a star pitcher in college who made minimum wage at a part time job then got a $500,000 signing bonus to play in the big leagues. Income averaging took into consideration those lower earning part time years as well as the big bonus. Yet that went away back in 1986. There are still some provisions for farmers but for the rest of us it went away with Reagan’s 1986 tax reforms.

Yet as it relates to the self-employed who are buying investment real estate, income averaging is still used, only this time by the bank or mortgage company evaluating a loan request. The self-employed borrower, just like someone receiving a regular pay check and W2, must show two years’ worth of self-employment income. The lender will then average the two years by adding the two net amounts together then dividing by 24 (months) used to calculate debt ratios. Yet unlike income averaging before 1986, there can be no wild swings in income or the loan request could be denied.

Lenders want consistent, year to year income. If one year the borrower made $20,000 then the next year $100,000 there could be a case made for an approval. Simply the business got continuously better and did things right and made more money. The bank could then ask for three years returns to see what happened in the year before the $20,000 mark. If the income were say $10,000 for the previous year, it could be reasoned the borrower’s business was on a good track. In this case, the bank might just average the $120,000 total and figure a $5,000 monthly income.

On the other hand, if the trends were reversed and the income from year 1 was $10,000, then $100,000 followed by $20,000, it’s likely the bank will deny the application and wait another year to see what happens. A business that goes from 10 to 100 to 20 is hardly consistent. That scares a lender.