June 17, 2019
Being self-employed certainly has its advantages as well as its disadvantages. But Orion’s brokers know that when it comes to obtaining a mortgage, self-employed individuals will find that in some ways, mortgage industry rules are more favorable toward those who are working for others. The income used to qualify a self-employed borrower must be averaged over one or two years of federal tax returns; whereas, an employee may use the income from the most recent raise.
With certain exceptions, the mortgage industry, including Orion, may not use the income generated by a self-employed borrower until the borrower has been in business for at least two years. Lenders are wary of new businesses since a high percentage of them fail in the first few years. In some cases, lenders will require averaging two years of “net profit” from the business to determine the purchasing power of the borrower. If the borrower has been in business for at least five years, one year of tax returns may satisfy lender requirements.
Cash that sits in a business account of a self-employed borrower that is expected to be used to cover the down payment or closing costs for a home purchase may or may not be acceptable. Business funds may be used as long as the borrower owns at least 50% of the business providing the underwriter approves of the cash flow analysis. The reasoning (correct or not) is that the business may be hurt by a depletion of business funds.
If business funds are to be used, the underwriter may accept a CPA letter stating the business will not be hurt by removing funds from a business account. Unfortunately, for liability reasons, brokers know that some CPAs are not willing to write that letter and with that in mind they tell clients that money not needed to keep the business healthy should be transferred into personal accounts several months before applying for a mortgage.
Brokers are very aware that some self-employed business owners may be inclined to overstate their deductions in order to minimize their income tax liabilities. But since the mortgage industry uses the business’ “net profit” as stated on its federal tax returns, the more deductions claimed, the lower the net profit. Since the mortgage industry uses the self-employed borrower’s net profit to determine a borrower’s home purchasing power, more deductions mean lower net profit which, in turn, means lower purchasing power.
Borrowers who own 25 percent or more of a partnership, LLC or corporation must provide the partnership returns and/or corporate returns for one to two years. For example, a borrower may consider himself an employee if he is working for a corporation but if he or she owns 25% or more of that corporation, the mortgage industry will treat the borrower the same as a self-employed borrower.
Orion has seen borrowers who own 100% of their corporation receive W-2 income from their corporation but when the corporate returns were analyzed, we found that the corporation was losing money. In this case, the negative income from the corporation would be subtracted from the borrower’s W-2 income to determine the borrower’s usable (for mortgage purposes) annual income. An individual or corporation can add back any depreciation claimed as an expense as it is considered a “paper loss,” not a true expense.