It’s no surprise if you’re self-employed and you’re trying to secure mortgage financing you potentially have a difficult time getting your loan approve. Let alone getting your loan to close at all. If you’re a self-employed, here are several lending factors you need to be aware of as a pertains to being self-employed and showing income to qualify for financing.
When you’re self-employed you need to have 2 years of federal income tax returns in order to qualify. The lender will average the 2 years of returns on most loan programs. This means you must have 2 years of showing taxable income on paper after expenses. However, there are some caveats you should be aware of. One of those caveats is if you’ve been filing self-employed for the most recent last 5 years, only 1 year of the most recent income tax return is needed in order to qualify. It goes without saying that the tax returns need to be filed and IRS validated. The mortgage company you’re working with will do what’s called a tax validation. They’ll ask you to complete a 4506 form which allows them to scrub the tax returns you provided against. They can sign off on the tax transcripts and they can only come from having your tax returns specifically processed via IRS.
Here’s where things can sometimes get challenging. If you had a good year in 2020, then you had a bad year in 2021 and your upcoming ’21 tax return is going to be relatively as good. Your taxes are not due until April 2022, and you can do an extension until October 2022. This will buy you some time to use the 2020 year’s tax return which in this case would be the prior year. However, for self-employed income to be counted, the lenders going to also ask for a year-to-date profit and loss statement. The year-to-date profit and loss statement is very important because it’s a measure or a gauge of your current year-to-date and present income. That income needs to be consistent with the most recent year’s tax filing. If the income is the same or higher, you’re in good shape. However, if your profit and loss statement is lower than the most recent year’s tax return it’s going to look on paper like you have declining income. This is something you’re going to need to be aware of as it pertains to secure mortgage financing when you’re self-employed.
So, let’s say for tax purposes you’ve been filing a schedule C, which is the most common type of self-employment business sole proprietor as an individual. This is the easiest income to qualify. It also has the highest tax exposure in terms of taxation directly proportionate to the income that you report on your net profit after deductions. If you were to go start a company and pay yourself a salary, it’s critical that you don’t bleed your company dries. Or make your company negative from an accounting balanced standpoint in order to pay yourself a salary. The reason for this is because if you’re essentially paying yourself a salary or any monthly income from a company that has no real revenue to support having that income. Meaning you’re avoiding paying taxes is paying taxes at the expense of also not being able to qualify for financing. Please note, always make sure to seek the proper tax advice for your unique situation. However, it goes without saying, more than likely, in order to qualify for financing, it’s gone to put you in the cross hairs with your accountant who is trying to help you get all your allowable deductions. Just because you can take allowable deductions does not necessarily mean that you should as it will drive your income down. When it comes to qualifying for mortgage income to offset a liability payment i.e., a mortgage payment is critical. So, the solutions that you have are as follows:
1. Pay the taxes associate with the income that you’re reporting and don’t try to take unnecessary deductions to drive your liability down if you’re trying to purchase or refinance a home.
2. Bring on another borrower. Maybe your spouse can sign on the mortgage with you, or you can add on a co-signer and refinance that co-signer off in the future if that’s a possibility.
3. Maybe you can look for a less expensive house supportive of the income that you’re showing.
4. Can you pay off a consumer debt such as a car loan or a credit card.
Not all lenders look at it this way, but make sure the lender is taking into consideration any business expenses specifically paid for by your business will help lower your debt-to-income ratio. So that car loan payment that’s reporting on your credit report, well guess what, if that’s paid from a business bank account and that’s itemized on your schedule C proprietorship tax return. That debt does not become an obligation against your debt-to-income ratio because it’s already accounted for in your monthly income.
The bottom line is showing the income that you can as it pertains to qualifying for a mortgage or be prepared to have to use an alternative method such as a co-signer, paying off debt or buying a more suitable house within your economic means. It also might mean having a pragmatic discussion with a lender and working with them over the course of time to give you a bigger, broader plan so you and your family can make a wise financial decision when you have the means to do so.
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