When applying for a mortgage, it’s well known that one of the lender’s first jobs is to make sure the borrower can afford the new mortgage payment. This process is determined by calculating debt-to-income ratios, or simply “debt ratios” and is measured by comparing a borrower’s total housing payment and the gross monthly income.
The debt ratio is important, but it can be tough to calculate if the borrower doesn’t get a pay stub. What if you are considered “self-employed” and pay yourself whenever and however you wish? How does a lender determine your income when figuring your debt ratios?
Two Year Minimum for Self-Employment
The first consideration is the two-year self-employment requirement. A lender will make sure that you’ve been in business in a self-employed capacity for at least two years. How do you prove that? You can provide a copy of your business license to start, but lenders will also want to see two years’ most recent federal filed income taxes, signed and dated.
Lenders have another definition for a self-employed borrower: anyone who receives more than 25 percent of their income in non-salaried pay can be considered self-employed. This primarily includes those who work on commission or bonus.
At the same time, it excludes those who own less than 25 percent of any operation business. A common example might be a partnership or LLC where the individual owns, say, 10 percent of the company. In this instance, the borrower is not considered self-employed.
You Might Be Self-Employed If…
You own your own business
You are a partner with at least 25% ownership in a business
You receive more than 25% of your income in bonus or commission income
You are a contract worker, even if you work for only one company
You receive 1099 forms instead of W2s
The bulk of your income is dividends and interest
You are primarily a landlord
Receive royalties
Required Documentation for Self Employed Borrowers
If you are self-employed, you will have to hand over more documentation than a salaried borrower would. Here are a few extra items you’ll need to provide:
Two years’ personal tax returns with all schedules
1099s
W2s from your self-employed business (if you pay yourself a salary)
Schedule C, D, E, F
Two years business tax returns with all schedules
K-1s
1120 (Corporate Tax Returns)
1120S (Partnerships and S Corps)
Year to date profit and loss statement showing current income is on track with previous years
CPA letter stating you are still running your self-employed business
Explanation letter if you receive most of your income at a specific time of year. In this case, it can look like your profit and loss statement is on track for lower income than in previous years.
If you are part of a business that has many owners, make sure all controlling parties agree that you can have access to business tax returns and can turn them over to a lender.
Self-employed Business Structures
There are many ways you may be self-employed, and underwriters look at each structure differently. Here are some common business structures.
Sole Proprietorship: One person owns and controls the business. Income is reported on schedule C of your personal tax return. An example would be the single owner of a landscaping company. Generally, sole proprietorships are smaller companies.
Partnership: Two or more people own and control the business. Profits from the business are split between the owners.
Corporations: Stockholders own the business. Usually, these are larger companies. A borrower who is 25% owner of a corporation is pretty rare to see on a mortgage application, but it happens. Getting the corporate tax returns can be difficult, since many parties may be involved in releasing them.
S Corporations: This is a corporation with a limited amount of stockholders. If you are the owner of an S Corp, you’ll need to supply your 1120S tax return.
IRS Tax Return Schedules for Self-employed Borrowers
Schedule C: Reports income or loss from a sole proprietorship.
Schedule D: Reports income from capital gains or losses. This type of income comes from sale of stock or real estate typically. Usually, these are one-time events and can’t be counted toward ongoing income. However, day traders, property flippers and the like may be able to use schedule D income if they prove three years’ worth of consistent income.
Schedule E: Income and loss from leased and rented real estate is reported on this form. Borrowers who maintain a full-time job while owning rental properties will have net income or loss from schedule E. The lender will add or subtracted this income from their employment income. Depreciation claimed on the schedule E can typically be added back to the borrower’s income.
Schedule F: This schedule is used for farming income.
Self-employed Tax Return Snafus
There are several things that can trip up a self-employed borrower when applying for a home loan and providing tax returns to the lender. Here are some of the most common:
Expenses. A lender will consider what a business made in net profit, not gross profit. For instance, a pet shop owner pulled in $80,000 last year in revenue. Not bad, right? But the business also had to pay rent, supplies, utilities and insurance to the tune of $30,000 last year. So a lender will only consider $50,000 in profit as real income.
Sometimes, business owners write off too many expenses. A laptop here, business mileage there – pretty soon the entire profit of the business can be written off. If your business makes $100,000 but you write off $90,000, guess how much the lender will say you made? Yep, $10,000 or just $833 per month. And you can’t qualify for much house with that.
Writing off legitimate business expenses is a wise move yet there are occasions where there are so many write-offs the business appears to make no money at all. If you plan to apply for a mortgage in the next 3-4 years, don’t go overboard on your write-offs.
Your Side Business. Many people work full time, yet have a side business, for which they file schedule C on their tax returns.
Note that if you plan not to disclose your side business for whatever reason, your lender will find out about it anyway. The lender will pull transcripts (called 4506 transcripts) directly from the IRS which will show income or loss from a schedule C business.
When you apply for the mortgage, be sure to tell your loan officer about your side business, and how much it made or lost during the last 2 years.
Many side business owners simply have a side business to write off expenses. If this is you, keep in mind that the lender will count your business loss against you.
For instance, if your tax returns show that you lost $12,000 in the prior year, your lender will reduce your qualifying current monthly income by $1,000.
Unlike positive business income, you don’t have to have the business for 2 years for it to count against you. If you just opened your side business, a loss for just one year will need to be considered.
If you closed your business after filing the previous year’s tax return, it’s possible for the underwriter to disregard the business loss. Write a letter saying how, why, and when you closed the business, and provide any documentation backing up the business closure.
Employee Expenses. Even if you’re not self-employed, you can claim non-reimbursed business expenses including mileage. You claim these on form 2106. These deductions are counted against your total W2 income. An example of employee business expenses are tools and supplies not provided by the company, non-reimbursed mileage to work-related meetings, and cell phone charges if you use your personal cell phone for work.
Two-Year Self-employed Average Income. When a lender reviews business income, they look at not just the most recent year, but a two-year period. They calculate your income by adding it up and dividing by 24 (months). For example, say year one the business income is $80,000 and year two $83,000. The income used for qualifying purposes is $80,000 + $83,000 = $163,000 then divided by 24 = $6,791 per month.
Declining Self-employed Income. But the lender also looks at something else when reviewing years one and two: consistency. The example above showed consistent income from year to year. What if the income looked more like this:
Year 1: $80,000
Year 2: $40,000
When you calculate a monthly income with these numbers, the amount is $5,000 per month. But a lender probably won’t approve this loan. Why? There is a serious decline in income and could indicate a failing business. Part of the income review process is determining the likelihood the income will continue and a business suffering from declining income can indicate the likelihood of continuance is in serious doubt.
However, there is no hard and fast rule regarding a specific decline in income, it’s up to the judgment of the underwriter approving the loan. A slight variance of say $80,000 to $70,000 might raise some questions but with a proper explanation, the application will still be approved.
There may be a legitimate reason for the lower income. The business owner took some time off to take care of a new baby. This easy-to-document occurrence can show why the income took a slight dip. In this instance, the underwriter might ask for three year’s tax returns instead of just two.
Cash Flow
A lender will also look at bank statements to examine the cash flow of the business. Is there enough monthly income to service debt? Some businesses rely on daily purchases of their goods and services such as a café or retail store. Others rely on just a few transactions per year.
When reviewing income, a lender wants to make sure there are enough funds in an account to pay the bills.
Using Business Accounts for your Down Payment and Closing Costs
In some cases, you can use funds from your business accounts from your down payment.
Sometimes, though, the underwriter will ask you for a letter from your CPA saying that taking money from the business won’t jeopardize ongoing health of the business. Your CPA may or may not be willing to write this letter.
The underwriter wants to verify that your business won’t be short on cash and be forced to take out loans or shut its doors due to lack of funds. After all, your business is the source of your income, and if your income stream stops, you may default on your loan.
Any business funds used for closing costs or the down payment on a home should be excess money that the business will not need for the foreseeable future.
Calculating Self-employed Income is Complicated
If you’re self-employed, you may disagree with the final income the underwriter determines for you. This is a common feeling experienced by many self-employed individuals.
Self-employed income calculations can sometimes boil down to judgment calls by the underwriter, especially for borrowers who have multiple businesses or properties, or whose business ventures are a bit outside-the-box.
If there’s any doubt how much the underwriter will calculate in your case, contact a mortgage professional for review. Also, most lenders offer an underwriter income review for more complicated tax returns, sometimes even before you officially apply for the mortgage.
This review gives everyone involved a starting point, since the underwriter comes up with qualifying income ahead of time. However, the final decision may not be known until final underwriting review.
The self-employed borrower does endure more scrutiny that the standard paystub/W2 employee. If you go into your loan application with the proper expectations, you’ll close your mortgage loan with very few surprises.