A business-savvy, self-employed guide to home financing in the digital mortgage era
Do you know how your self-employment income qualifies you for a home loan?
More than half of our clients are self-employed, so we know how to help entrepreneurs, investors, and small business owners strategically acquire quick and simple home financing. Here are three points to consider before applying for a home loan with self-employment income: how your income is structured, how this income qualifies, and how your situation is evaluated.
With self-employment income, it’s critical to understand how you receive this income; this has to do with the way you’ve structured your business entity. The three most commonly used entity structures for self-employed borrowers are Sole Proprietorships, Limited Liability Corporations (LLC), or S Corporations.
Each has different tax implications; please note we do not advise our clients on taxes but for this article, we'd like to share an additional resource. If you are a Sole Proprietor, you will prepare form Schedule–C on your personal tax return. If you are working under an LLC or S Corp, you will file business returns, receive a K1, and in some cases with an S Corp, also a W-2. These are the documents your lender will review when considering your eligibility for home financing. Next, we’ll explain how each of these will be evaluated.
How Do You Receive Self-Employment Income?
- Sole Proprietorship
- Limited Liability Corporation (LLC)
- S Corporation
How Does My Self-Employment Income Qualify?
When a lender looks at the income you earn from self-employment, they will not simply look at your company’s revenue; lenders are more focused on the net income you derive from your business.
If your company earns $600,000 of total revenue and you are offsetting this revenue with $400,000 of company expenses, your net income, in this case, would be $200,000. This is the amount that would be considered your qualifying income for your home financing, pending any add backs.
By add backs, we mean if you have $400,000 of expenses, there are a couple of write-offs we can add back to increase your qualifying income, depending on the expense. The two most common write-offs are home offices and expenses related to business equipment or real estate.
For example, the IRS allows business owners to spread the cost of large equipment, meaning if you purchase a big machine to make your widgets at a cost of $100,000, and the useful life of that machine is five years, the IRS allows you to spread the expense $20,000 per year for five years. Because the expense in the subsequent years didn’t affect the cash flow of the business, lenders allow it to be added back.
How Will My Situation Be Evaluated?
To qualify your self-employment income towards your home financing, lenders focus on two things:
Firstly, they evaluate the trend of your business. How is the business performing over time: is it growing, maintaining, or declining? If your income declined over the past two years, your lender will take the lower amount; conversely, if your income increased over the past two years, your lender will take the average of the past two years.
By way of example, if your net income in 2016 was $100,000 and your net income in 2017 was $200,000, the lender will average the two years and use $150,000 as your qualifying income. Conversely, if your net income in 2016 was $200,000 and your net income in 2017 was $100,000, the lender will use the declining amount of $100,000 as your qualifying income.
It’s important to note that when your income is, in fact, declining the lender will dig a little deeper to determine that your business is not continuing to decline in the current year. You should be prepared to have your CPA provide year to date financials for your company supporting that things are level or back on the upswing.
Secondly, your lender will require a two-year history to confirm that your income is likely to continue at your current earning levels for at least three years. This data supplements the lack of employer verification of your income. Keep in mind, it’s more difficult to gain a financing approval when your business earnings are declining year over year. Be very clear with your lender about both the current and future state of your business.
Although these are general guidelines, there are exceptions to these rules as lenders understand that every situation is unique and certain situations causing declining income can be both explained and supported. To recap, those steps are outlined below.
Steps to Earn Eligibility for Non-Salaried Income
- Establish History (2 Years)
- Amount Trend & Eligibility Proof (3+ Years)
Obtaining home financing with self-employed income, it is best to prepare for your submission. We recommend organizing the last two years of tax returns, both personal and business, and any K1s received during that time, along with any other supporting documentation to comprehensively evaluate your eligibility.
For your employment income to be considered, you must prove you’ve been working in a self-employed capacity in the same line of work for the past two years. Additionally, you must show a consistent trend of income, and prove that this trend is likely to continue over time.
Before you get started, we recommend getting a clear picture and understanding of what is outlined above. Often, we find that self-employed borrowers qualify for less than they expected because of their income structure and tax write-off amount combined with net income levels that fluctuate dramatically year over year.
Our home loan advocates work directly with our clients to ensure that you understand your maximum eligibility and secure a comfortable monthly payment. Contact us at 1-888-210-5232 to get started on your very own modern financing.