From a Mortgage Lender’s perspective, the most complicated Mortgage Applicant is often the Applicant that is Self-Employed.
Full Documentation Loan Files are demanded in today’s Mortgage lending. IRS transcripts are requested (and received) on the vast majority of Mortgage Loan Applications. With Self-Employed Borrowers, the only way to verify income (and expenses) is through an Individual U.S. Tax Return and the Tax Returns filed by the business they own. And that is true whether that business is a Partnership, Corporation, (S, C, or LLC), or otherwise.
In most cases, no paystubs exist, as the potential Borrower’s business is not paying the Self-Employed owner as a consistent wage like they do an employee. The same is generally the case for W-2‘s. Often, no regular monthly deposits of a consistent amount are available for review either. So, the end analysis rests solely on the business and personal tax returns filed. Those, in turn, are supported by Tax Schedules and Bank Statement Activity.
So you say … what’s the problem?
As a rule, the majority of Self-Employeds incur expenses in the course of conducting their business. There are tax advantages to them for reporting those expenses … and again, the great majority of Self-Employeds take full advantage of their expense “write-offs”. Typically, tax advantage expenses are shown on tax returns as a means to reduce income … which in turn, reduces the amount of taxes paid by the Self-Employeds. That is the whole idea of filing in this manner and the advantage found in doing so.
Unfortunately, when those Self-Employeds try to secure a Mortgage loan, this advantage … reflected on their tax returns as “reduced” income (Net Income), serves as that Self-Employed person’s “Qualifying Income” that is reviewed by the Underwriter.
There is really no guesswork in this equation. Net Income after expenses (with some exceptions and “add-backs”) is what a Will County and Chicagoland Mortgage Banker and Underwriter use to determine a Self-Employed Borrower’s income level. I arrive at the Net Income by reviewing the Self-Employed’s last two (2) years of filed Income Tax Returns.
Often times, an Underwriter requires that a Year-to-Date Profit and Loss Statement from the Self-Employed Borrower be submitted. This is especially true if the loan is being made in the 3rd or 4th Quarter of the year. In some case files, only the most recent tax year documents are required, but often times two (2) years are needed.
For that reason, it’s a rule-of-thumb lending requirement that a Borrower be Self-Employed for a minimum of two (2) years in order to qualify for a Mortgage Loan. This two (2) year history of reported income can also apply to those that are Commission Employees, or 1099 wage earners that serve as Independent Contractors (IC).
While all of these rules and guidelines are often viewed as overly rigid and inflexible, quite honestly, they make sense. There are cases where less than two (2) years of these types of income are allowed and “approvable”. But in the context of this post, we’ll refer to those as rare exceptions.
The bottomline is: What the IRS knows and has on record for these kind of Borrowers is what a Mortgage Lender’s Underwriter will see … and even more importantly, must use for determining income.
Self-Employeds hoping to make application for a Mortgage must understand that fact and know that HOW they file their Tax Returns for the two (2) years previous to their Mortgage Application will impact their ability to borrow money. Like every other taxpayer, a Self-Employed’s tax returns must be a fair and accurate depiction of their true income.