Recently Self-Employed: What income do lenders look at

4 Replies

Hello!

TL:DR What income do loan officers look at? Total, Adjusted Gross, or Taxable Income?

More in-depth: Should I file as sole-proprietor and reduce my tax liability by reducing my adjusted gross income (pays more SE tax) or should I file as S-Corp. Total taxes paid comes out about the same, but in the former case, I would have to contribute a lot to an individual 401k to reduce my AGI.

I was recently downsized from my job a few months ago, and as such, I've been informed that I will not be able to use my past W-2 income to qualify for a mortgage. I am also not interested in finding another job in the same profession/industry as 1. I believe the industry is dying and 2. There are more fulfilling things I would rather do. I am currently earning unrelated (to my previous field and real estate) business income and would like to reduce my taxable income as much as possible without severely hurting my ability to get a conventional loan. My pickle for this year is that my W-2 income at my old job was fairly high, raising my tax liability without helping me qualify income for a loan. Next year will be a different situation. I understand that the best answer probably depends on my specific situation, but I wanted to see from those who are more knowledgeable which the better route would be.

Thanks!

I'm self employed and I purposefully do not take all the deductions I am able to take because I want my income to remain high for borrowing purposes. I do not use any entities to lower my tax liability. If you want to borrow at high levels you need to pay tax at high levels unfortunately. Can't have your cake and eat it too. I can't Tag them as I'm on mobile but @Chris Mason and @Upen Patel are both loan officers who could speak to the specifics of what lenders are looking at.

@Russell Brazil Thanks for the mention.

@Don Pham 1st off you will need at a min 1 full year (minimum) of self-employed income to qualify for a conventional mortgage. With regards to what to report. For self employed individuals, we would go digging into your personal and business tax returns, to see if any deductions you have take can be credit back to you as income. e.g. putting money into a 401(k)/SEP-IRA is gone, can't come back. Depreciation can be added back.

I am not a tax professional, so don't want to advise you on that. I will echo what @Russell Brazil said, you can't have your cake and eat it to. So deduct what you thing is fair, but don't over do it. Might come back to bite you.

Hi @Don Pham ,

  • Write off as much depreciation, including vehicle depreciation from business miles driven, as your CPA says is lawful to write off.
  • Don't write off any meals & entertainment at all, unless your CPA tells you that, lawfully, you must. 
  • Don't drink the kool aide and form any entities, unless there is a net tangible benefit aside from an entity guru getting a paycheck from you for setting them up.
  • We do not use gross income, AGI, or net income, for our mortgage math. We have our own weird math.
My pickle for this year is that my W-2 income at my old job was fairly high, raising my tax liability without helping me qualify income for a loan. Next year will be a different situation. I understand that the best answer probably depends on my specific situation, but I wanted to see from those who are more knowledgeable which the better route would be.

You didn't go into WHAT your new business income is, or if you were after a jumbo loan or not, but some income types require 1 year, some require 2 years, depending on loan program. Any time you declare your income substantively different on your tax returns from one year to the next, you risk resetting to only having one year of income from that income source. 

So if this year you sell lemonade and put it on Schedule C as "lemonade sales," and then next year you sell lemonade and put it in a "lemonade sales" S Corp, some investors (particularly jumbo) will view that as 1 year Schedule C, 1 year S Corp, no two year history of receipt on tax returns, loan denied.

In general, for self employed folks that want to qualify for a mortgage within the next few years, pick how you're going to report that income to the IRS, and stick to it. No drinking "entity guru" kool aide, in general entities make it harder - not easier. I'm two weeks into working with one gentleman right now, and still can't even preapprove him, because he has fifty zillion freaking LLCs and S Corps that all (on paper, at least) do absolutely no business, but we still need to track down all those tax returns, document YTD P&Ls, bla bla bla. If his tax returns reflected reality, which is a single sole proprietorship that SHOULD be perfectly fine on Schedule C (or at most a single S Corp), it would have been a 20 minute preapproval. 

Thank you all for the replies--they've been very insightful.

@Chris Mason Wanted to clarify some things--do you mean avoid claiming M&E expenses as much as possible unless I'm legally required to? If so, why is that and how does that differ from other travel expenses like plane tickets?

To add a little more detail to my specific situation, I am an educator in the broadest sense. I tutor/teach academic subjects as well as recreational subjects like dance and musicality. 

Historically I have filed Schedule C with my major expenses being in travel (combination of mileage as well as airfare/hotel for related conferences) and depreciation (equipment). Until this year, since I was employed full time in an unrelated job, I have filed Schedule C losses. Since beginning August when I've got more hours to put in, I will probably end up netting about 40k on Schedule C (unless I go the route of electing S-Corp). My thinking was (though probably faulty based on your comment regarding mortgage math) if lenders look at income before the adjustments in lines 23-36 on form 1040, I would just take the deductions there for HSA and 401k to lower taxable income (instead of within the S-Corp), thus having my cake and eating it too :) 

As you can tell from the numbers, I'm not really looking at mega deals. I carry 0 debt and am just looking to finance a few 100k loans on small multi-families, even in a cash out refinance situation where I buy the property cash and finance a year later. I'm just a little irked at having to pay taxes on 100k+ income but only have ~40k qualify for 2016 when I try to apply for a mortgage.

On another note, would I even have a chance at qualifying with a reported loss the year prior? Say for example that there was a net loss of 5k for year 1 and a net profit of 65k for year 2, the reason being more hours put into the business. Assuming no other factors, would this be seen as (-5,000+65,000)/24 = 2,500 monthly or just "not approved"? 

BTW I apologize if I'm misusing or misunderstanding terminology and concepts as I'm pretty new to the world of real estate investing and loans.

Thanks!

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