In today’s challenging credit market, one of the most scrutinized mortgage borrowers is the self-employed client. Self-employed is defined by agents such as Fannie Mae, Freddie Mac and the Federal Housing Administration, as having 25 percent or greater ownership in a business or having income flow to a personal tax return from a sole proprietorship, partnership, limited liability corporation or corporation. Self-employed professionals frequently use tax deductions to offset income, however, this strategy may prove challenging when applying for a home mortgage.
IncomeGenerally, Fannie Mae, Freddie Mac and the FHA require a two-year federal tax return history. It is important to provide your lender with these finalized returns and the supporting returns for the other entities that provide income or loss to the personal return. These returns will be matched up to the IRS-issued transcript for verification by your lender. Some lenders also may require a current year-to-date profit and loss statement for the business if it has been more than 120 days since the last tax return was filed. Since it is common for the self-employed to offset income with tax deductions, it is important to understand where income can be added back to help qualify for a mortgage. The following items may be added back to calculate income: depreciation, depletion, nonrecurring loss, business use of the home, amortization and casualty losses. Some items on the return also may reduce income available for qualification, including unreimbursed expenses, nonrecurring income, and meals and entertainment.
For rental property owners, rental income is calculated using the IRS Form 1040 Schedule E and will offset mortgage payments of principal, interest, property taxes and homeowners insurance – known as PITI. Depreciation, homeowners insurance and property taxes also are added back to the calculation.
Another important element of the business return is the “notes due in one year” section. Large notes that are not renewed may have a big impact on the business, capital and cash flow, therefore, documentation is required to explain the notes due and whether or not the institution holding the note will renew that debt.
AssetsBusiness owners often make large or irregular deposits into their accounts for a variety of reasons. If those funds are being used for the mortgage down payment, reserves or closing costs, it is important to document the source of those deposits.
Funds moved from business accounts to personal accounts also require a paper trail. A letter from an accountant stating that the funds can be used for personal reasons without negatively impacting the business may be required as well as a cash-flow analysis on the business.
It also is important to note all rental properties owned by a self-employed borrower who is purchasing or refinancing a primary residence may require six months of PITI in a reserve account.
When planning to purchase or refinance, the self-employed client should work with a tax professional to present a balanced tax return that will meet the debt-to-income ratio required to qualify for a home mortgage. This ratio is generally 29 percent for the PITI and 45 percent for all debt; however, underwriting criteria may vary between the different loan programs and loan products.
The bottom line is if you are self-employed and have solid income, assets and good credit, you are likely to qualify for a home mortgage as long as you provide the proper documentation to your lender.
Michael Frerking is senior vice president and residential lending manager at Guaranty Bank. He can be reached at mfrerking@gbankmo.com.
