Self-Employment: for many of us, this is the essence of the American Dream. Taking risks and going it alone, hopefully for better and sometimes for worse. Our economy is arguably anchored by a foundation of small businesses that hire, grow, and most importantly, innovate.
The prevailing impression is that self-employed borrowers can’t get mortgage terms as favorable as employed borrowers (let’s call them “W2-ed” borrowers), if they can get a mortgage at all. Fortunately, that is not truly the case, although self-employed borrowers will have some unique challenges (and unique opportunities) in qualifying for a mortgage. I’ll address some of those challenges, how they can be mitigated, and touch on some advantages that self-employed borrowers enjoy.
The Bane of Self-Employment: Documented Income
Underwriters need you to be able to prove your income. For W2-ed borrowers, this is fairly straightforward: there are paystubs, W2s, or employers themselves that are fairly easy to access. However, self-employed borrowers usually don’t issue themselves paychecks or W2s (and even if they do, you could imagine how underwriters would scrutinize that). The best documentation that underwriters can get regarding a self-employed borrower’s income is his/her tax returns. Just like W2s and such are reported to the IRS, tax returns are how self-employed borrowers report their income to the IRS (and subsequently pay taxes).
One of the great perks of self-employment is the ability to write-off expenses in order to reduce taxable income. Do you use your cell phone for work? You can deduct it from your income. Same thing with travel expenses, storing inventory, buying a four-wheeler to entertain clients (!), etc. Self-employed borrowers are able to reduce their taxable income, often paying fewer taxes than comparable W2-ed borrowers. However, there is a flip-side: that reduced taxable income is the same figure that underwriters will use for your qualifying income when you apply for a mortgage. If you earned $50K/yr, but wrote it down (through business expenses) to $30K/yr, it is going to be more difficult -if not impossible- to qualify for most mortgages.
It’s a double-edged sword: the more you write down, the less you pay in taxes, but the lower mortgage amount you can qualify for.
Key Points to be Aware Of
The key to getting a loan when you are self-employed is advance planning. You first need to know some things about how underwriters will calculate your income. This subject could be a weeklong seminar in itself, so I will just point out some key items-
· You have to use the same tax returns you filed with IRS – You can’t have 2 sets of tax returns. If you do, you’ve got bigger problems…
· Your total income is considered, not your taxable income– This is line 22 of your federal income tax return (your 1040s).
· The last 2 years’ tax returns are considered – If your income is less for your 2013 returns then it was for your 2012 returns, they will use just your 2013 tax returns. However, if your 2013 income is more than your 2012 income, they will consider the average of the 2 years.
· Some income can be “added back” – Things such as depreciation or property taxes can be added back to your total income. This is especially applicable if you have rental properties.
What to Do
As I mentioned, planning is the key when being self-employed and trying to get a mortgage. Since tax returns are used as your income documentation, it may mean waiting until the next year’s returns are prepared.
· Calculate what you can qualify for now – This is an oversimplification, but for both your 2013 and 2012 tax returns, take your 1040 line 22 income and subtract any non-recurring losses or gains (like IRA distributions, unemployment compensation, etc.). Now average those figures for 2012 and 2013 and divide by 12. This is the figure that can be used as your qualifying income. Now take that number and multiply it by 0.35; the result will be, approximately, your highest allowable monthly mortgage payment (including taxes and insurance). Keep in mind that if you have a lot of other debts, they could reduce your highest allowable monthly mortgage payment.
Example: 2013 Total income: $65,000, 2012 Total income less Unemployment compensation: $40,000. The average is $52,500, giving you $4375/month in qualifying income. Your highest allowable monthly mortgage payment is $4375 * 0.35 = $1531.
· Calculate what income you will need – Let’s continue the previous example and say you wanted to buy a home (or refinance) that would require a mortgage payment of $2000. With your 2012 and 2013 tax returns, you don’t yet qualify, but you may be able to with your 2014 tax returns. To figure out how much income you will need to show on your 2014 returns, we work backwards.
$2000 / 0.35 = $5714 in required monthly income. That’s $68,570 a year, so if we double that and subtract your 2013 Total income, we get $72,140, which is how much income you will need to show on your 2014 tax returns to obtain this loan (remember that we are no longer considering your 2012 income, since we only look at the 2 most recent tax returns).
If you were aggressively writing off business expenses before, you could ease up a bit and show over $72,140 on your tax returns for 2014. You will pay a little bit more in taxes, but you’ll qualify for the mortgage. This is the “silver lining” of being a self-employed borrower: you can control the income reported and consequently, control the mortgage (within reason).
Tips
I will say again, this is an oversimplification. A good loan officer (like…me!) will be able to accurately determine what you qualify for and what needs to happen to make it work. Here are some general tips for self-employed borrowers that are thinking about getting or refinancing a mortgage:
· Start using a CPA – Taxes get a lot more complicated when you’re self-employed and a good accountant can save you money, protect you from audits, etc. Plus they carry a lot of weight with underwriters.
· Be fair – I’m not going to approach the ethical/moral/legal arguments of whether or not you should write off that matinee movie, but I do believe in karma, so show an honest income and pay an honest tax. In the long run, you’re better off getting a mortgage with which you are truly matched (considering true income).
· PLAN – If you’re thinking about buying a home within the next 2-3 years, talk to a loan officer (me) now to see where you stand and where you need to be.
· Other Options – There are other options for self-employed borrowers, such as Stated Income Loans. These are not nearly as attractive as they used to be before the real estate crash, but they are making a slow and controlled comeback. If you have a substantial amount of equity and/or cash to use as a down payment, and don’t mind a slightly higher interest rate, a Stated Income Loan might work.
Bottom-line
Self-employed borrowers have just as many mortgage options as W2-ed borrowers, they just need to understand the significance of their income reporting and plan accordingly.
