When it comes to obtaining a mortgage as a self-employed individual, understanding how your taxes impact your loan approval is crucial.
Nathan Jennison of Mortgage Architects shares insights into why proper tax planning is essential if you’re looking to purchase a home or refinance in the next two years. Here’s everything you need to know to set yourself up for success.
Why Self-Employed Borrowers Face Unique Challenges
Unlike W-2 employees, whose income is considered stable and easy to calculate, self-employed individuals encounter additional scrutiny. The reason? Lenders often perceive self-employed income as less predictable.
However, there’s a major advantage: as a business owner, you can actively influence your income levels through strategic decisions, which can lead to higher loan approval amounts. But this flexibility comes with trade-offs.
The Tax Dilemma for Self-Employed Individuals
As self-employed professionals, many of us aim to minimize our tax liability by maximizing deductions and hiring CPAs to optimize our tax strategy. While this approach reduces taxes owed, it also lowers the income that lenders consider when determining mortgage eligibility. Here’s why this is a problem:
- Lender Criteria: Mortgage approvals are based on taxable income. The more you write off, the less income is “visible” to lenders.
- Long-Term Impact: Excessive write-offs can limit your borrowing capacity, making it harder to qualify for the home you want.
The Importance of Sending Tax Drafts
Jennison emphasizes the importance of sending your tax drafts to your mortgage advisor before filing them. This step allows for a thorough review to ensure you’re balancing tax savings with income visibility for loan purposes. Here’s the process:
- Draft Review: Submit your tax drafts before finalizing them.
- Recommendations: Your mortgage advisor will analyze the numbers, identify areas for improvement, and make suggestions to align your taxes with your mortgage goals.
- Approval Planning: By optimizing your taxable income, you can enhance your chances of mortgage approval.
Key Considerations for Self-Employed Mortgage Applicants
1. Understanding Depreciation
Depreciation is a critical factor for self-employed individuals. While the IRS treats depreciation as a business loss, mortgage lenders add it back to your income during their calculations. This adjustment can significantly improve your approvable income.
Example:
- In 2022, a business reported $5,000 in depreciation.
- In 2023, that number jumped to $45,000.
- For IRS purposes, this reduces taxable income, but for lenders, it boosts approvable income.
2. Year-to-Year Income Trends
Lenders also examine your income stability over the past two years. Declining income may raise red flags, but with proper documentation and explanation (like high depreciation in a specific year), you can present a stronger case.
3. Averaging Income
Typically, lenders average your income over two years to determine your eligibility. For instance:
- 2022 Approveable Income: $187,000
- 2023 Approveable Income: $200,000
- Average Monthly Income: $16,128
For businesses with stable income over five or more years, lenders may consider using just one year of tax returns, offering greater flexibility.
How to Optimize Your Mortgage Readiness
To ensure your finances are in top shape for mortgage approval, follow these steps:
- Plan Ahead: Start tax planning at least two years before applying for a mortgage.
- Seek Professional Advice: Work with a mortgage advisor and CPA who understand the nuances of self-employment and mortgages.
- Maintain Consistency: Avoid drastic changes in income that may alarm lenders.
- Track Depreciation: Use depreciation to your advantage by understanding how it impacts your approvable income.
FAQs About Mortgages for Self-Employed Individuals
Q: Can I still qualify for a mortgage if I maximize deductions?
Yes, but it depends on how your deductions impact your taxable income. Sending your tax drafts for review can help you strike a balance.
Q: How far back will lenders look at my income?
Typically, lenders review the past two years of tax returns, though some exceptions allow for just one year.
Q: What documents do I need to provide?
Be prepared to share:
- Two years of tax returns (or one year if eligible)
- Profit and loss statements
- Business bank statements
- Proof of business stability
Take Control of Your Mortgage Future
As a self-employed individual, your tax strategy can make or break your mortgage application. By sending your tax drafts for review, you’ll gain expert insights into how to optimize your financial position and increase your chances of approval. Remember, proactive planning is key to securing the loan you need.
If you have any questions or need personalized advice, don’t hesitate to reach out. Your mortgage success story starts with smart tax planning today!
