Qualifying for a Mortgage When You’re Self-Employed

Thinking about going into business for yourself? If so, here’s another topic to add to your list of issues to consider when deciding whether to go it alone: qualifying for a self-employed mortgage is a considerably more complex process than it would be if you remained a regular ol’ W-2 employee. In fact, depending on your situation—and who you choose as your mortgage broker—you may not even be able to qualify at all. The same holds true if you’re already self-employed—even if you’ve been a sole proprietor or small business owner for years. Why? Because most self-employed individuals tend to deduct or “write off,” much of their profits.

The Downside of Deducting

New business owners are often happily surprised to see that net income on your self-employed tax return is considerably different than net income on your profit and loss (P&L) statements. Indeed, tax write-offs are one of the perks of self-employment, as they allow you to keep more of the money you make and fork over less to Uncle Sam. When you’re self-employed, in most cases, you and/or your accountant will strive to uncover as many deductions as possible. These write-offs reduce your taxable income, and they come not just in the form of cash you lay out for business expenses, but also in the form of non-cash transactions, such as depreciation of office equipment and miles driven to and from business obligations. If you run a home-based business, you can deduct noncash transactions that include a portion of your existing mortgage or rent, utilities, property upgrades, and more.

As a result, you’ll find that some of the deductions shown on your return won’t show up on your P&L. So, even though your little operation might be humming along quite nicely, your tax return will likely show considerably lower net income than is reflected on your profit and loss (P&L) statements. This is no problem…until you attempt to apply for a mortgage as a self-employed individual. Since lenders typically review your last two or three years’ worth of tax returns to determine if you meet their income requirements, qualifying for a mortgage as a self-employed worker is tricky, at best.

Weigh Your Options

So, what can you do about this problem? Are you destined to stay in your current home forever? Luckily, no. But now that you know the challenges that await you when applying for a mortgage as a self-employed worker, you have some decisions to make. Depending on when you plan to purchase a new home, you could:

1. Wait to start your own business until after you’ve bought your new place. Obviously, this is only an option if you haven’t yet quit your day job, so to speak.
2. Hold off on buying a home for a few years, and, in the meantime, take only minimal deductions on your tax returns to ensure you have an adequate debt-to-income (DTI) ratio.
3. Devise a strategy that will allow you to qualify for a mortgage even as a self-employed business owner who takes full advantage of tax deductions.

Strategize Your Way into a Mortgage

If you’re ready to buy a home, and you’re confident you (and your partner, if applicable) have enough income to adequately cover a monthly mortgage (as well enough money socked away for a down payment and related fees), you need to enlist help from the right professionals: a certified professional accountant (CPA) and a mortgage broker.

A CPA will be able to construct accurate, complete P&L statements that show the true earnings of your business. These statements should only include expenses that are directly related to the business, such as money spent on supplies and equipment and fees paid for networking events or professional memberships. It should include line items like professional liability insurance and the cost of gas to get to and from work-related meetings, but it shouldn’t include expenses such as premiums for self-employed health insurance or the monthly vehicle lease costs for a car used for both personal and business purposes. This ensures that your statements reflect only the direct costs of running the business and effectively increases your net earnings (compared to what you show on your tax return).

You can show your P&L statements to your lender along with your business’ bank statements, which should show that you have enough cash flow to run your business and pay yourself a wage high enough that it meets DTI ratio requirements. You should also ask your accountant to write a letter on your behalf certifying that your business’ net income is higher than what’s reflected on your returns.

Choose the Right Mortgage Professional

In addition to working with a CPA, you should also employ the services of a mortgage broker (rather than a bank loan officer) who understands how small businesses operate. Bank loan officers and even mortgage brokers without specific experience with self-employed mortgage applications will often fail to properly assess your situation—he or she may even outright refuse to consider loan applications that don’t have adequate income reflected on returns.

A mortgage broker with knowledge of how a self-employed individual makes and reports income can more accurately evaluate your cash flow situation. He or she will ideally have knowledge of the different ways in which small businesses are often structured. These brokers understand how to read self-employed tax returns, which are often much more complex than those of W-2 employees. Armed with the right expertise, your broker can better assess your organization’s financial health, and, as long as everything else checks out, will probably be able to approve your loan, even when others can’t.

As your own boss and only employee, you are responsible for sales, financials, taxes, legal issues, accounting, technology problems, and everything in between. The ability to juggle multiple demands on your time is key for a self-starter. While there is no guarantee of success, there are resources and partnerships that can help you along the way.