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Filing Taxes as a Self-Employed Borrower

Couple looking at each other outside their new home

Being self-employed can offer freedom and flexibility, but it also requires additional layers of documentation, especially when applying for a mortgage. This article is to help self-employed borrowers understand how filing their taxes impacts their mortgage application. We’ll cover different strategies you can use to work successfully with a lender and improve the experience of securing a mortgage.

The importance of tax returns

When looking at your mortgage application, lenders analyze your financial stability to ensure you can repay your home loan. For self-employed borrowers, federal tax returns play a crucial role in this evaluation. Lenders typically will look for applicants to have at least two years of continuous self-employment income documented on their tax returns. This helps lenders assess the trends in your business earnings and expenses, providing a clear picture of your financial health.

However, some lenders may consider one full year of continuous self-employment income if it is supported by additional factors, such as previous successful experience in the same field of work. It’s essential to work closely with your tax preparer to ensure your tax returns accurately reflect your income and business expenses.

A lender may average two years of your business income or use the most recent, depending on how long you have been self-employed and the fluctuation year after year. Is the income showing a decline or incline? These are some of the puzzle pieces that a lender will be looking for when reviewing your tax returns.

Additional factors for self-employed borrowers

Self-employed individuals are evaluated on a handful of added factors when applying for a mortgage, including income variability, tax deductions, and a lack of traditional documentation. Let’s explore these in more detail:

Income Variability

The most significant challenge for self-employed borrowers can be income unpredictability. Unlike salaried employees who receive a consistent paycheck, being self-employed may mean income can fluctuate month to month or even seasonally. Lenders will look for stable, consistent income to reduce risk.

Tax Deductions

Many self-employed individuals take advantage of business-related tax deductions to lower their taxable income. While this is a smart tax strategy, it can sometimes reduce the amount of income lenders are willing to consider when evaluating a mortgage application. For instance, if you deduct business expenses that lower your taxable income, that may be viewed as a true cost to the business, even though your actual cash flow may be higher. There are items a lender can consider to offset this, like adding back in the depreciation expenses.

Lack of Traditional Documentation

Oftentimes, self-employed individuals do not have the same payroll documentation or W-2 forms that traditional employees can present. Instead, they must rely on tax returns, profit and loss statements, and other business documents, which may feel cumbersome to gather. With the level of documentation needed, it can sometimes take a lender slightly longer to review the request compared to a W-2 employee.

Strategies for streamlining your mortgage application

Despite the additional considerations, self-employed individuals can successfully purchase a home with proper planning, documentation, and the right approach. Here are some strategies to help you navigate the home-buying process:

Maintain consistent and accurate financial records

Keep detailed and accurate records of your income, business expenses, and taxes. A well-organized year-to-date profit and loss statement can go a long way in supporting your business’s financial stability and providing a full picture of your income stream to lenders. Ensure your tax returns accurately reflect your earnings and consult with a tax professional to optimize your financial presentation.

Consider a larger down payment

A larger down payment can demonstrate financial stability and reduce the risk for lenders. If you can put down 20% or more, you may offset some of the challenges that come with fluctuating income. A larger down payment, although not required, will also lower your loan-to-value (LTV) ratio, making it easier to qualify for a mortgage and potentially securing better loan terms.

Show proof of cash flow

In addition to tax returns, many lenders want to see proof that your business generates consistent cash flow. This can include bank statements, contracts with clients, and other documentation that shows a stable stream of income. If you have a proven track record of successful business transactions and predictable cash flow, lenders may be able to better understand the business income to better support your loan application.

Consider alternative loan options

If traditional mortgages are too difficult to secure, you may want to explore alternative loan options such as:

  • Non-Qualified Mortgages (Non-QM Loans): These loans are designed for borrowers who don’t meet the standard qualifications, including self-employed individuals. They may have more flexible underwriting standards.
  • Portfolio Loans: Many of the guidelines on what a lender can utilize for income and documentation for self-employed borrowers come from the investors on conventional loans, Freddie Mac and Fannie Mae. Some credit unions and lenders offer portfolio loans that may be more flexible with the requirements. These loans may be a better option in some circumstances than a conventional loan with strict guidelines.

Improve your credit score

Your credit score plays a critical role in your ability to secure a mortgage. If you have time before you plan to apply for a loan, take steps to improve your credit score. Pay down existing debt, avoid missing payments, and ensure your credit report is accurate. A higher credit score can help you secure better loan terms, even if your income is less predictable.

Conclusion

Buying a home as a self-employed individual may have a couple of extra steps, but it is certainly in reach with the right approach. By maintaining solid financial records and saving for a larger down payment, you can increase your chances of success in the home-buying process. While it may take a bit more effort and preparation than for traditional W-2 employees, self-employed individuals can still enjoy the rewards of homeownership by planning and presenting complete financial documentation to potential lenders.

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