Mortgage Financing for Self-Employed Borrowers
There's a common misperception that self-employed borrowers cannot qualify for mortgage financing in today's strict lending environment. While securing a loan for self-employed borrowers is a bit more complicated, advance preparation greatly improves the odds of a favorable outcome. Fannie Mae guidelines (followed by most lenders and loan programs) consider any individual with a business ownership interest of or exceeding 25% to be self-employed. There are four basic structures of self-employment (sole proprietorships, partnerships, corporations, and S corporations) and a lender's underwriter will have different requirements for their analysis of each one. Instead of looking at the specifics of each classification, let's outline self-employment challenges in more general terms. Here are a few things to keep in mind as you prepare your loan application.
Self-employed workers generally seek to maximize their business expense write-offs in an effort to minimize their tax liability. Unfortunately, the lender's underwriter will use the adjusted income to qualify debt-ratios and borrowers who are overly aggressive with their deductions may not get the financing they want. Some items, such as deductions for home office, depletion, or depreciation for business equipment may be added back into the borrower's income.
Lender guidelines generally require a two-year history of self-employment, supported by two years' personal and business tax returns to qualify income. (Conversely, if a self-employed borrower begins a salaried position in the same line of work, their new income can be used right away.) The two-year history is needed to demonstrate the viability of the business, the stability of the borrower's income, and to determine the business' actual income by averaging gross receipts against expenditures and losses. There are a few lenders open to consideration of self-employment history with just a one-year history, but this is rare. If a self-employed borrower left a salaried position in a related industry, is working with the same clients, and can substantiate their income and expenses, a shorter history may be accepted.
Lenders are extremely sensitive to declines in income and must have a reasonable explanation for the decline along with assurances that the business will remain profitable and the borrower will be able to service the credit liability under consideration. While income is generally averaged over two years, if the most recent returns show a significant decline, the underwriter will use the current, lower figure.
Capital Gains or Losses
Capital gains or losses are generally considered one-time events and are therefore not used in determining income. But self-employed borrowers who show a pattern of asset turn-over with regular gains or losses will have these analyzed and may need to provide up to three years returns for review. An example of a business that falls into this category might be a business that buys, improves or refurbishes, and then resells a product.
Application Requirements For Self-Employed Borrowers
Tax returns (all schedules) for two most recent years. (Needed to determine business income and the ability of the borrower to continue to meet the obligations of the proposed housing debt under consideration.)
1099s,W2s, pay stubs, and other evidence of income received.
Business licenses for most recent two years or a CPA letter verifying the self-employment status of the business over at least the same period of time.
CPA letter regarding business assets if these are needed for the loan, such as to cover closing costs. CPA must verify that the borrower has 100% access to funds and that withdrawing funds will not have a negative impact on the business.
Profit and Loss statement, detailing year-to-date income and expenditures, signed by CPA or borrower. The P & L statement is required to verify stability of the business and income should be reflective of profits and losses showing on past tax returns.
Some characteristics of the various self-employment structures:
Schedule C, Sole Proprietorship
The individual is personally responsible or all debts or liabilities and the business' income or loss is folded into the individual's returns. Depletion and depreciation are added back to income, while the tax year's "meals and entertainment" exclusion must be deducted. For rents showing on Schedule E, depreciation related to income or loss must be added back to net gain or loss.
In a partnership, two or more individuals form a business and share in profits, losses, and the responsibility of running the business. In general partnerships, each partner is fully responsible for all debts of the business and the actions of each partner. In limited partnerships, each partner's liability is limited to their percentage of vested interest in the partnership. In both partnerships, form 1065 is filed along with Schedule K-1 for shares of income, credits, and deductions. Income is listed on Schedule E. Each partner's proportionate share of depreciation and depletion can be added back into their income as these are non-cash expenses. These credits, however, must first be reduced by the proportionate share of the partnership's total obligations that are due in less than one year.
Corporations, Form 1120
Corporations are state-chartered businesses owned by stockholders who are not liable for corporate debts. Lenders will analyze business filings on form 1120 to determine the adjusted business income. The underwriter will then determine the borrower's corporate interest, generally listed in the "compensation of officers" section and multiply the business' income by the borrower's percentage of ownership to determine a qualifying income.
S corporations are generally smaller businesses with a limited number of shareholders. Gains and losses are passed onto shareholders, who are then taxed at their individual rates. Form 1120s is filed and income or loss is passed onto Schedule E. The owners' primary source of income shows in the form of W2 wages. Depreciation and depletion can be proportionately added back to income, but must first be reduced by the individual's personal share of obligations that are payable within one year.
The information listed above is a very basic overview and must not be considered in any manner as tax advice. You should consult with your CPA or financial planner for guidance.
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