When you are trying to get a mortgage loan, you have to prove your income. Which, when you are a W-2 employee, requires a lot less paperwork than a self-employed person needs to have. There is a lot to love about being self-employed. You get to set your own hours, you do not have to report to a boss anymore, and there are some great tax write-offs that you can take advantage of. Of course, once you are self-employed, you probably work longer hours than ever before, and instead of a boss, you have clients or customers to answer to. But the tax write-offs are still there and can be a great perk to a self-employed person. If you have a good accountant, they can help you find any business expenses that you may have missed, saving you a lot of tax money.
The problem that many self-employed people will encounter when trying to obtain a mortgage loan is that many big box banks will only count their taxable income, which in many cases is not enough income to qualify for the desired mortgage. So, what is a self-employed person to do in this case? Should you write off fewer deductions to make your income look bigger? LoanBud conducted a study recently with 521 self-employed people who have tried to get a mortgage in the last seven years, and 53.17% of them considered writing off fewer things on their taxes to increase their qualifying income. In this article, we will talk about why forgoing tax deductions to make your taxable income higher is not the right option when you are looking to obtain a mortgage loan.
Deductions That Can Be Added Back To Net Income
Your net income is the amount of taxable income left after your tax deductions. While leaving off deductions from your taxes is one way to give yourself a higher net income, this is not the only way to do it. There are some business expenses that an underwriter at a mortgage lender will add back into your net profits. You can claim depreciation on the equipment and hardware of your business. Depreciation is the tax-deductible accounting loss that will show the decreasing value of something as it gets older. For example, your car is worth less today than it was when you bought it — unless you have a classic car — so if the car is a business vehicle, that could potentially be something added into the deprecation for your business.
If you have any one-time expenses, as well as the documentation to prove that they are one-time expenses, you can get them added back into your net income. You will also need to show your lender why they are one-time expenses and not something that will be coming up again.
Do you have a home office? If you do, you probably use the home office tax deduction, which is a popular one if you are a freelancer working from home. If you do claim the home office tax deduction, that is another tax write-off that you can get added back into your net profit by the underwriter.
If you are using your business account to cover a personal expense, by noting that, you may also be able to get that expense added back into your net profits, too; you will just need documentation that you are doing so.
Tax Returns Don't Always Show The Real Picture
While tax returns alone can often be enough to prove the income of a W-2 employee, they do not always paint a real picture of your income when you are self-employed. Your CPA will utilize every tax write-off possible so you can pay as little in taxes as possible. This is great at tax time, but can make it more challenging when it comes time to get a mortgage.
Let's face it - business owners, freelancers, and entrepreneurs will try and take every single deduction they possibly can to reduce their tax bill. Travel for business, auto expenses, car leases, meals, supplies, repairs and other line items on can sometimes be a little...inflated on the returns.
We understand that as a self-employed person you are going to try and reduce your taxable income as much as possible. This is why at LoanBud we allow an option to qualify using your bank statements or 1099's instead of your tax returns. Many lenders are inflexible and still require tax returns for all self-employed applicants.
Tax Write-Offs and the Debt-to-Income Ratio
Part of the reason that tax write-offs can hurt your chances of getting a mortgage is that they can raise your debt to income ratio. Your debt-to-income ratio is the percentage of your income that is going to pay debts versus what you keep. For example, if you have a car payment and credit cards, those are part of the debt portion of your debt-to-income ratio. Lenders use your debt-to-income ratio to see how much you can afford and if you have too much debt promised to too many organizations already. Typically, a lender does not want to see a debt-to-income ratio of more than 50%, though different lenders and different loan programs have specific requirements for the exact percentage of your debt-to-income ratio. Most lenders prefer a debt-to-income ratio of 43% to qualify you for a mortgage, but this does vary.
By using tax write-offs, you are lowering your take-home pay, which will raise your debt-to-income ratio accordingly. It can be tricky to balance having a low debt-to-income ratio while still taking advantage of your tax write-offs unless you come to a mortgage lender like LoanBud, who understands the complexities of self-employed income and offers you other ways to qualify besides using tax returns. However, most lenders will not allow you to prove your income in any other way, as 62.57% of our survey respondents wished they could do.
Higher Tax Bill or Higher Mortgage Payment
If you are considering forgoing tax write-offs to qualify for a mortgage, consider the amount of additional taxes you may have to pay. For some entrepreneurs who write-off everything, you may end up having to pay tens of thousands of dollars in additional taxes to show enough net income to qualify. Now consider that you may need to do this for two consecutive years, and you can start looking at a really big number to pay in taxes.
Some lenders such as LoanBud will offer the option to qualify using bank statements or 1099's instead of tax returns. The interest rate is slightly higher, but would you rather pay a couple hundred dollars more per month on your mortgage, or pay an extra $30,000 or more in taxes to try and qualify for a mortgage? Besides, the extra interest you pay on a mortgage is generally tax deductible, reducing your tax liability.
Separating Personal and Business Debts
Since your name is on all of your business information, it can be hard to sort out what debt is part of your personal debt and what is part of your business' debt. If you're self-employed and using tax returns to qualify for a mortgage, there are certain expenses that if paid by your business can be added back to your qualifying income. Here are some examples of when business debts can be added back to your qualifying income:
- You pay the debt out of a business account, not a personal account.
- You have made at least 12 months of payments out of your business account.
- You have never made a late payment on that debt in the past 12 months.
- The expense is shown on your tax returns.
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Other Qualifying Factors for a Self-Employed Mortgage
Your net income and debt-to-income ratio are not the only things that a lender will look into when determining if they should give you a mortgage. Let's take a look at some of the other things lenders look at when determining if you qualify for a mortgage loan.
FICO Score
One of the major factors that lenders will look at is your credit score.
If you are looking to get a mortgage, whether you are self-employed or a W-2 employee, you need a good credit score. However, if you are self-employed, it is even more crucial for you to have a good credit score. Most lenders, no matter what your employment status is, will require you to have a FICO score of at least 620. The higher your credit score, the better your chances are of paying a lower interest rate, and the more likely you will be able to receive the loan amount that you need to purchase a home. There are also more mortgage loan programs available to you if you have a good credit score.
Owning a business may not impact your credit score unless you have taken out loans or lines of credit for your business under your name instead of the name of your business. Using a personal credit card for business expenses can also make it impact your credit score; we recommend getting a business credit card and only using it for business expenses. Before applying for a mortgage, you should consider paying your credit card balances down as low as possible. Lowering the percentage of available credit that is utilized, also known as the "utilization rate", is the fastest way to increase your credit score for a mortgage. Just remember the utilization rate is based on the amount of credit being used at the time your statement cycle closes; so consider paying card balances down a couple days before the closing date of the statement cycle.
Self-Employed Mortgage Down Payment
When you're self-employed, the minimum down payment percentage will be based on the income documentation used, your FICO score, and the loan amount. Down payments start at 3% if using tax returns, and 10% if using alternative income documentation. It's best to speak with a lender to determine the minimum down payment that is applicable to you.
When you apply for a mortgage, the lender expects that you have enough money in a personal savings account to cover your down payment, closing costs, and several months' worth of mortgage payments. This needs to be kept separate from your business savings, and if you do use business funds to help with any of this, you will need documentation that using your business funds is not going to harm the profitability of your business.
Stability of Self-Employment Income
If you are an employee, a mortgage lender will most likely assume that you will be working for that company indefinitely, even though that is not a safe assumption. If you are self-employed, on the other hand, lenders see your income as riskier, so they will look more closely at your finances than they will at someone who is an employee. A lender wants to make sure that your self-employment income is stable and is not declining. Because of this, you will be asked to show recent bank statements and/or a Profit & Loss statement so show the income you've received year-to-date.
You will also need to show a track record of receiving self-employment income. So, you'll have to provide the last two years of your income, and ideally there will be a trend of increasing income instead of decreasing. At LoanBud, we can look at exceptions to the two-year requirement for receiving self-employment income, and can sometimes use just one year of income.
Getting a Mortgage Loan Without Sacrificing Tax Deductions
The best way to get a mortgage without not sacrificing tax deductions is simple - just don't use your tax returns to qualify! At LoanBud, we know that it can be hard for a self-employed person to get a mortgage loan, which is why we designed created a company specifically designed for the self-employed.
Instead of tax returns, you can use 12 to 24 months of bank statements, or 1 to 2 years of 1099's to qualify. Depending on the type of business, we will use between 50% - 85% of the bank statement deposits as qualifying income. For our freelancers and others who receive 1099 statements, we can use up to 100% of your 1099 income as qualifying income. In both cases, your tax returns will not be required.
Your Pre-Approval Letter May Not Be Valid
It can be risky to put an offer on a home when you are self-employed if you go to a bank that will not analyze your income before handing you a pre-approval letter. If you make an offer on a home, and they did not look closely at your income beforehand, you might find yourself getting denied a mortgage after you are under contract to purchase the house. This is a real problem. In a recent survey by LoanBud conducted by Pollfish, 50.29% of survey respondents who received a mortgage pre-approval were later denied by that lender. If this happens and the seller is unwilling to wait for you to secure a new loan, you may end up losing your home and your earnest money deposit.
If you are self-employed and looking to buy a home, instead of forgoing your tax deductions to have a higher net income for your mortgage application, contact LoanBud today. Since we specialize in self-employed mortgages, you can feel confident in your pre-approval letter and not be left scrambling to find a new mortgage loan at the last minute.
*LoanBud is not a tax advisor and the advice provided are based on general tax principles. You should consult a tax advisor for further information regarding the deductibility of interest, charges, or any other business related expenses as they pertain to your specific situation.
