Mortgage Mastery for the Self-employed

Over the years, I’ve noticed that many of my self-employed clients approach the mortgage process with some degree of trepidation.

In this post, I aim to share concepts and demystify the paperwork and process for hopeful homebuyers who happen to be self-employed.

And because I believe it’s never too soon to start planning for your mortgage, I’ll share a few concepts that may make securing your loan easier, even if (especially if) you’re not ready to begin your house-hunt right away.

This is a long post, but full of good stuff… so take a deep breath and read on!

Am I self-employed?

Before we get started, we should define who is, from a lender’s perspective, self-employed. The definition is really simple: for mortgage purposes, you are self-employed if you own 25% or more of a business. This is true even if you are on the payroll, receiving a paycheck and a W-2.

Secondary self-employment

And it’s possible to be self-employed — and not — simultaneously. You may have a regular job and self-employment on the side. Any secondary income (whether or not it is from self-employment) usually has to have at least a two year history to be considered as a source of income for loan qualifying.

If your self-employed side gig losses money (even if it’s a brand new venture), in most cases, an underwriter will want to deduct your loses from your other income. There are exceptions, however; Fannie Mae, as one example, generously allows lenders to disregard losses from secondary sources of income.

Entities and documentation required

Businesses can be structured a few ways. Your tax documents vary a bit depending on how you and your accountant have elected to set up your business:

• Sole proprietor – You are a sole proprietor if you report your business income and expenses on a Schedule C, filed with a Form 1040, personal income tax return.

• Partnership – Businesses owned and operated by several individuals are often a partnership. A partnership files its own tax return on a Form 1065. Profits or losses from the business are passed through to the partners to include on their personal tax returns. Each partner receives a Form K-1 with their share of the profit or loss.

• Corporation – Standard corporations (“C corporations”) file a Form 1120 and pay taxes directly to the IRS. But another common form is an “S corporation”, which files a Form 1120S and then (like a Partnership), passes profits or losses through to each shareholder on a Form K-1.

The documentation a self-employed borrow will be required to provide depends on how their business is structured.

• Personal tax returns (Form 1040) – All self-employed borrowers must provide their personal Federal income tax filing, complete with all Schedules and Statements.

• Business tax returns (Form 1065, 1120 or 1120S) – If your business is a partnership or corporation, you’ll also need to provide the Federal income tax filing for the business, again complete with all schedules and statements.

• Form 4868 – If your loan is scheduled to close on or before April 15th and you’ve not yet filed the prior year’s tax return, you’ll need to provide a copy of the extension form your accountant sent to the IRS.

• Profit and loss statement(s) – A profit and loss statement (or P&L) is a document that states the income and expenses over a period of time. Income minus expenses is your profit (or loss). You’ll need to provide a year-to-date P&L, outlining your income and expenses through at least the end of the quarter before you close on your loan (eg., through June 30th if you are buying in August). If your prior year’s income tax filing is on extension, you’ll also need to provide a P&L for that year.

• Balance sheet – Often (but not always), you’ll be asked to provide a balance sheet for your business. A balance sheet lists your business’ assets and liabilities. Assets minus liabilities is the net worth of your business.

Income is income – so long as it’s distributed

No matter the structure of your business, all of the income your business generates is treated the same for loan qualifying purposes. Whether income is paid to on a 1099, as salary, as distributions or as your share of the profit from a partnership or corporation, it is all included as income for mortgage qualifying. This is true, even if you’ve changed from one business structure to another.

It is, however, important to note that in most cases, only income distributed to you can be used to qualify for a loan. More on this below.

Two years history usually required

Nearly all loan programs require you to be self-employed for 2 years before your income can be used to qualify for a loan. Even if your business is thriving, even if you have a contract with a client that guarantees payments, you’ll likely need 2 years under your belt.

Exceptions to this rule do exist, for very specific circumstances: If you’ve been in business for less than two years, but more than a year, have a year of income tax returns filed and a stable history of income and employment in the same line of work, it may be possible to qualify for a mortgage using your self-employed income.

Factors under consideration

Before approving your loan the underwriter is required to analyze all of the following:  

• The stability of your income

• The ability of the business to continue generating and distributing sufficient income for you to make your mortgage payment

• The location and nature of your business

• The demand for the product or service you offer

• The financial strength of your business

Averaging income over time

One way lenders assure your business shows stability and the ability to pay is by averaging income over time. In general, the income shown on your past 2 filed tax returns will be averaged over 24 months to determine your qualifying income. The underwriter will look at your profit and loss statement to confirm that your income has remained stable since your last tax return was filed. If your profits are growing rapidly year-over-year, this math does tend to understate what you are earning.

There are exceptions to the requirement to average income over 2 years. Fannie Mae and Freddie Mac, for example only require 1 year of tax returns if you’ve been operating your business for at least 5 years. There are even a limited number of jumbo loan options that ask for just one year of tax returns.

Trends matter

If your income is stable or increasing, from one tax year to the next and from your last tax year to your P&L, you’ve likely demonstrated the stability and strength needed for loan approval.

However if your business’ net income has declined from one year to the next or from your last tax year to your year-to-date P&L, all hope is not lost. You’ll have the opportunity to write a letter explaining what caused the decline and make a case that your business will continue to generate income sufficient to pay the loan.

Did you invest profits into marketing or inventory or capital to build your business? Did your business recently go through a transition? Did you win a new contract or client? Did a prior year include an unusual influx of income or an unusual expense? Think about how you can tell the story of your business.

And think about what documentation you can provide to support your letter. If your business is seasonal or goes cycles that last longer than a year, the standard documentation might not tell the whole story. Showing month-by-month income and expenses for prior years could help the underwriter get a better picture of how your income ebbs and flows in a typical year. Providing older tax returns, can help an underwriter see multi-year cyles.

Moving your business

Another time you could be asked to write a letter explaining something about your business is if you are moving your business from one geographic location to another. If your business is rooted in place, the underwriter may not feel that your history of earnings is a good representation of stable income going forward. An example would be a general contractor who would probably need to ramp up business over time, with new clients, after moving to a new area.

However if your business is not tied to location (maybe you are a designer with clients all over the country) or you travel for work and just need access to an airport (such as a freelance photographer), a letter that helps the underwriter understand your business should do the trick.

Giving yourself a raise won’t matter

Being your own boss means, of course, that you can give yourself a raise, any time you want. Increasing your salary probably will not help (or hurt) your ability to qualify for a loan. Your lender is looking for the total income your business generates over time. Whether your business pays you a handsome salary and then barely breaks even or you pay yourself a pittance and then take substantial profit-sharing distributions, it’s all the same to your lender.

Retained earnings are probably not “income”

When a partnership or corporation makes a profit, you get to choose to distribute the profits to yourself or leave them in the business as “retained earnings”. In most (but not all) cases, retained earnings are not considered “income” for loan qualifying. Remember that the underwriter is looking for the income available to you to pay your mortgage payment. Until profits are distributed to you, they are an asset on your business’ balance sheet and not yet income to you.

This can be confusing, I admit. As the business owner, you can distribute profits to yourself any time you want. And if your business is a partnership or S Corp you even pay income tax on your profits, distributed or not. Nonetheless, this rule applies. As you plan for a home purchase, consider distributing profits so the underwriter can see your business’ true capacity to generate income to you.

Analyzing tax returns

First a personal aside: If someone told me my career as a loan officer was over and made me to pick a new line of work, I’d want to be a tax preparer. I find tax returns endlessly fascinating… so consider yourself warned. Now we’re going to climb into the weeds a little (not all the way) and talk about tax return analysis.

Remember our big picture goal is to determine the amount of income your business generates. Put another way, we want to know the business’ cash flow. Your tax returns are a great place to start, as you are legally obligated to accurately report your income and expenses to the IRS. However, the bottom line on your tax returns does not perfectly represent your cash flow, because tax rules muddy the waters.

In some cases, the IRS allows you to write things off as an expense that were not really part of your cash flow. In other cases, you have expenses that IRS rules won’t allow you to deduct. Your lender will rummage through your tax return and adjust for each.

Things we may be able to add back include.

• Depreciation – When you put an asset into business use, the IRS allows you to deduct its value, spread out over time, as depreciation. We can add this write-off back to your bottom-line. Depending on the nature of your business, this can be a significant adjustment.

• Depletion – If your business involves natural resources, like gas, oil, timber, mining, quarrying or the like, depletion is the write-off you are allowed to claim for “using up” the resource over time. Again, it’s not an actual expense to your business, so we are permitted to add it back.

• Non-recurring losses – If your business had any one-time losses, from a natural disaster, fire, theft, litigation, writing-off a bad debt or the like, we should be able to add these losses back to your income. Expect the underwriter to ask for supporting documentation to prove the nature of the loss and that it is not likely to recur.

• Amortization – Amortization is a lot like depreciation. It refers to allocating the cost of an intangible asset over time. A good example would be a patent that lasts for a certain period of time. Like depreciation, we get to add back this write-off.

• Mileage – If you have a vehicle in business use, the IRS permits you to write-off a set cost per mile. For 2018, the mileage rate is 54.5 cents per mile. Of that, 25 per mile is considered depreciation for the vehicle. We can add back 25 cents per business mile written off, just as we’d add back other depreciation.

• Business use of home – IRS rules may also permit you to claim a home business write-off. If your home workspace qualifies, you’ll write off some of your rent or mortgage, utilities, property taxes, insurance, repairs and more. Although these are expenses to you, they are part of the cost of the home you own or rent and not considered a true business expense. You have to live someplace whether you are self-employed or not, after all.

And, on the flip side, things we will probably be required to deduct include:

• Non-deductible meals and entertainment – IRS rules generally only allow you to write off a portion of your expenses for meals and entertainment. Just because you can’t write-off the entire expense, doesn’t mean it didn’t happen. For an accurate picture of cash flow, we have to adjust your income downard for the portion you were not allowed to write off.

• Non-recurring income – Just as we may be able to add back non-recurring expenses, so too, we must deduct non-recurring income. Credit card rebates, prize winnings, profits from the sale of business property that are not an ongoing part of your business… anything along this line will be deduced from your qualifying income.

• Debts payable in under 1 year – Corporate tax filings include a balance sheet (found on Schedule L). If your balance sheet includes any short-term debts (those payable in under a year), the amount shown will be deducted from your qualifying income unless, perhaps, you can show you have ample assets on hand to pay the debt in question. This line item can make a big difference in the amount you qualify to borrow. Over the years I’ve seen a few instances when an accountant put a debt not truly due on under a year on this line. If your corporate tax returns show a large amount on this line and you’re not sure what debt is being referenced, you may want to ask your accountant for more information.

It’s important to note that exactly which adjustments are allowed varies a bit from lone loan program to another, especially when it comes to jumbo loans. If you want to see an example, you can check out Fannie Mae’s “Cash Flow Analysis” form here. But note the formula shown is not universal. Many jumbo loans use the more conservative standards set forth in a document the Consumer Financial Protection Bureau refers to (rather dryly) as Appendix Q.

When your lender insists on seeing a copy of your tax returns early in the loan process, it’s because we need to analyze them and research loan options to find the loan options that best fit your business and goals.

Business assets

You will be required to document the source of all the funds you’ll be using to pay your down payment and closing costs. Additionally, most loan programs require that you show a certain amount of money left over in savings after closing (called “reserves”).

Self-employed borrowers often plan on dipping into business assets to cover some or all of their down payment and/or demonstrate the required reserves. A few loans prohibit the use of business funds for closing, reserves, or both. Most loans allow the use of business funds so long as special rules are followed.

When business funds are in the mix, the underwriter will usually perform a cash flow analysis performed to verify that the withdrawal of funds will have no negative impact on business operations. You’ll be asked to share bank statements for the underwriter to analyze (4 months is common). Some loan programs require a letter from your CPA stating the withdrawal of funds to buy your home will not harm your business. However, many CPAs are unwilling to write such letters.

If you are holding funds in your business account that you plan to use for your down payment or closing costs or will be needed to cover reserves, get started talking to your lender as early as possible. If you plan far enough ahead, you may even be able to transfer the necessary funds from your business to a personal account early enough to eliminate some potential questions and paperwork.

Business Liabilities

If you run a small business, there’s a pretty good chance that some of your business debts are in your name. You may have a car loan the business pays or credit cards you use for the business that show up as a personal liability on your credit report.

Lenders use a ratio of your debt to your income to determine the amount you qualify to borrow. As a default, all debts on your credit report are included in your personal debt-to-income ratio (DTI). However, if you can prove your business has paid the payment on one more more bills an underwriter will generally exclude the debt from your DTI.

Excluding a debt can make a huge difference. On a 30 year fixed rate today, every $100,000 you borrow costs just over $500/mo of payment. So removing a $500 car payment from your DTI could allow you to qualify to borrow about $100,000 more.*

To exclude the payment, you’ll need to provide proof the business has paid the last 12 months of payments. This can be the front and back of 12 months of canceled checks or 12 months of business bank statements showing the payment clearing the account. The underwriter will also look to see that the interest cost for the debt is included in your business tax filing.

And an important note, make sure your business has been paying the creditor directly. If your business reimburses you for a payment that you make on its behalf, the debt will still be considered “yours”.

What if I need a Plan B?

If some or all of this sounds a little daunting and you’re worried you may not qualify for a loan or you’d rather simplify the paperwork you provide, there are a growing number of alternative documentation loan programs, many of which are designed especially for self-employed borrowers. Click over to this earlier blog post to read more.

The Takeaway — Plan ahead and work with experts

As you may have figured out, helping our self-employed clients achieve their goals of homeownership (and investing in real estate) is a passion of mine. And the fact that I’m writing this post in September is not an accident. I’m a big believer in planning ahead (click here for another reason).

If you are self-employed and thinking of buying a home next year, now’s the perfect time to do a little advance legwork. You still have time, as the tax year winds down to strategize how you’ll handle your distributions, assets and receivables.

But of course, if you’re ready to dive into the fray and write an offer today, that’s okay too. Just be sure you put yourself in the hands of a mortgage team with the knowledge and experience to make your dreams of homeownership a reality.

Call 503-799-3711 or email juleef@rate.com. We love our entrepreneur clients!

*Loan amount and monthly payment estimation provided for illustration purposes only and is not intended to provide mortgage or other financial advice specific to the circumstances of any individual and should not be relied upon in that regard. Guaranteed Rate, Inc. cannot predict what your estimated closing costs will be.

Applicant subject to credit and underwriting approval. Not all applicants will be approved for financing. Receipt of application does not represent an approval for financing or interest rate guarantee. Restrictions may apply, contact Guaranteed Rate for current rates and for more information.

All information provided in this publication is for informational and educational purposes only, and in no way is any of the content contained herein to be construed as financial, investment, or legal advice or instruction. Guaranteed Rate, Inc. does not guarantee the quality, accuracy, completeness or timelines of the information in this publication. While efforts are made to verify the information provided, the information should not be assumed to be error free. Some information in the publication may have been provided by third parties and has not necessarily been verified by Guaranteed Rate, Inc. Guaranteed Rate, Inc. its affiliates and subsidiaries do not assume any liability for the information contained herein, be it direct, indirect, consequential, special, or exemplary, or other damages whatsoever and howsoever caused, arising out of or in connection with the use of this publication or in reliance on the information, including any personal or pecuniary loss, whether the action is in contract, tort (including negligence) or other tortious action.

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