Self-Employed and Buying a Home? Your Tax Return May Not Tell the Whole Story

By Todd Evenson, Connect Home Loans

If you’re a W-2 employee applying for a home loan, determining your income is often fairly straightforward.

If you’re self-employed, it’s a different story.

Business owners naturally try to operate their businesses efficiently and take legitimate deductions available to them. But when it comes time to qualify for a mortgage, those deductions can make the income shown on a tax return look considerably different from the income a lender may actually be able to use.

That’s why self-employed borrowers shouldn’t automatically assume they won’t qualify based simply on the bottom line of their tax return.

There may be more to the story.

W-2 Income Is Usually More Straightforward

For a traditional W-2 borrower, lenders generally look at recent paystubs, W-2s and employment history to establish qualifying income.

A borrower with a stable salary may be able to qualify using their current earnings rather than simply averaging previous years.

Bonuses, commissions and other variable income can require additional history and documentation before they can be counted.

The basic idea is straightforward: lenders want to establish that the income being used to qualify is stable and reasonably expected to continue.

For business owners, establishing that income can require a much closer look.

Self-Employed Income Isn’t Just the Number at the Bottom of Your Tax Return

Self-employed borrowers will commonly need to provide personal tax returns and, when applicable, business returns.

Those returns tell the lender what the business earned, but they also contain expenses and deductions that may need to be evaluated differently for mortgage qualification.

This is where working with someone who understands self-employed income can make a significant difference.

Certain deductions reduce taxable income but don’t necessarily represent the same reduction in a borrower’s actual cash flow. Depending on the loan program and circumstances, a lender may be able to make adjustments when calculating qualifying income.

Examples can include depreciation and certain other non-cash expenses.

The important distinction is this:

Taxable income and qualifying mortgage income are not always the same number.

Even Business Vehicle Expenses Can Matter

Consider something as ordinary as a business vehicle.

A self-employed person may deduct eligible business vehicle expenses or mileage when preparing their taxes. For mortgage underwriting, however, the treatment of those expenses may be different depending on how they are reported and the applicable loan guidelines.

The same principle can apply to other expenses appearing on a business owner’s returns.

This doesn’t mean every business deduction simply gets “added back.” It means an experienced loan professional needs to understand what the expense represents, how it was reported, and what the specific loan guidelines allow.

That’s an important distinction because two borrowers with the same taxable income could potentially have very different qualifying income.

Rental Property Owners Can Have the Same Problem

Real estate investors add another layer of complexity.

Rental properties reported on Schedule E can contain significant expenses that reduce the property’s reported income.

Sometimes an unusually large expense truly represents an ongoing cost of operating the property. Other times, it may have been a legitimate one-time expense that doesn’t accurately represent the property’s normal performance.

That distinction can matter.

I recently worked with a self-employed client purchasing their 11th income property. After reviewing the borrower’s properties and documentation, I identified four expenses of:

• $14,450

• $42,725

• $55,412

• $48,500

Together, those expenses totaled $161,087.

Because the expenses could be documented and evaluated appropriately, we were able to present the situation to underwriting rather than simply accepting the initial numbers at face value.

It required additional documentation, a spreadsheet and some explanation to the underwriter.

But that’s part of the job.

A complicated tax return doesn’t necessarily mean a borrower can’t qualify. Sometimes it means the return needs to be properly understood and documented.

More Years in Business Can Sometimes Help

Another misconception is that every self-employed borrower will always be evaluated exactly the same way.

Loan guidelines can vary depending on the borrower’s history, business structure, loan program and other factors.

For an established business owner with a longer history of self-employment, there may be circumstances where less historical income documentation is required than someone who has only recently become self-employed.

That can become particularly important when the business has grown.

Imagine that last year’s income was significantly higher than the year before. Simply averaging the two years could produce a very different result than qualifying under guidelines that allow greater consideration of the more recent performance.

Again, the details matter.

Don’t Decide Whether You Qualify Before Talking to a Lender

This may be the most important takeaway for business owners.

It’s easy to look at your tax return, see all the deductions you’ve taken and assume:

“There’s no way I’m going to qualify for the house I want.”

Don’t make that determination yourself.

A knowledgeable mortgage professional can review the entire financial picture and determine which income and adjustments are actually permitted under the loan program you’re considering.

That doesn’t mean deductions can simply be ignored or that every expense can be added back. Mortgage underwriting has specific requirements, and the documentation has to support the numbers.

But a tax return is designed to determine taxable income.

A mortgage analysis is trying to determine stable qualifying income and the borrower’s ability to repay the loan.

Those are related questions, but they aren’t identical.

Local Home Values Continue to Make Planning Important

For buyers here on the Central Coast, understanding borrowing power is especially important because even relatively small differences in qualifying income can affect the homes available to you.

Paso Robles home values remain substantial, which means preparing early and understanding how your income will be evaluated can make a meaningful difference before you begin seriously shopping.

For W-2 employees, that may mean understanding how bonuses, commissions and variable income will be treated.

For business owners and real estate investors, it may mean reviewing tax returns well before making an offer.

The best time to understand how a lender will view your income isn’t after you’ve found the house you want. It’s before you start shopping.

About the Author

Todd Evenson is with Connect Home Loans and a member of Early But Worth It. Todd helps homebuyers, business owners and real estate investors navigate mortgage financing and understand how their individual income and financial circumstances affect their borrowing options.

Expert Editorials are contributed by Early But Worth It members to share professional knowledge and help our community better understand the industries they work in.