Hello home loan seekers!
Welcome to part 2 of the three part series on income. I can foresee this becoming a much larger conversation than just these three parts, but for now, I think this provides a good foundation. If you’ve landed here first, may I recommend that you go back and read part one. It sets the stage for this blog post series and may help with the initial building blocks of this topic.
Today we are exploring self employment income.
With self employment income, we are moving away from W-2 income and into 1099. The 1099 refers to the form you receive from the IRS when you are a self employed person OR a contract employee. It basically means the employer dose not collect taxes from your paycheck, and you are responsible for reporting and paying your own taxes. We will look in depth at contract employment later in this post, but for now, let’s focus on a 1099 self employed buyer.
Self employment is defined by income received from a business where you own 25% or more. There are four basic structures:
- Sole Proprietorships
- Limited Liability or “S” Corporations or
Self employment income can be used as effective income if you have at least a two year history of receiving such income. If you have been self employed between one and two years, the self employment income can only be counted as effective income if you were previously employed int the same line of work where you’re currently self employed OR in a related occupation for at least two years.
The stability component of self employment income is perhaps the most challenging thing to prove. This is because the lender will use your tax returns to determine the stability of self employment. Generally, for small businesses, there is no third party to request an employment verification from, so we have to rely on tax returns. If the tax returns reflect income that is stable or increasing it’s acceptable as effective income. If the income from the business reflects a greater than 20% decline over the two year analysis period, the lender must downgrade the file and request that an underwriter manually underwrite it. Manual underwriting is a beast unto itself, and deserving of a future post. For now, manual underwriting is most closely aligned with a denial. Loads of lenders don’t do manual underwriting and even if they do, the level of scrutiny is such a heavy lift, it’s been my experience that it’s just not worth it. The better option may be to wait until you have two years of stable income or find a lower priced home where the self employment income isn’t necessary.
Documenting Self Employment Income:
Third party verification is the name of the game in the home loan approval process. With self employment income, the most common third party income verification source is tax returns. The lender must review both personal and business tax returns to determine self employment income. Business returns are not required if:
- Individual federal income tax returns show increasing self employment over the last two years
- Funds to close are not coming from the business
- The mortgage to be insured is not a cash out refinance
In addition to the most recent two years of business and personal tax returns, the lender will also request a year to date (YTD) profit and loss (P&L) statement and a balance sheet. The lender will only request these pieces of information if more than one calendar quarter has passed since the most recent tax filing. Additionally, the balance sheet is only required if the borrower does not file a schedule C as a part of their personal tax returns. It’s important to be extremely explicit about the use of the P&L statements. Year to date P&L’s are not used to determine effective income. They are used to give the lender a picture of where the business is going. For self employed borrowers, lenders can only use income that can be verified by a third party. That third party is the IRS via filed and verified tax returns. I’ve had many conversations with buyers about why we can not take a YTD P&L that shows more income than the most recent year tax return. If we can’t verify it, we can’t use it. It’s simply a guidepost, not a determinant of income.
There are loan products that will allow you to use the YTD P&L but it has to be audited by a CPA. Audited P&L statements are several thousands of dollars and generally cost prohibitive for the marginal amount of income you will receive by using them. But it is important to note that it is possible to use your current annual salary, vice the last tax years salary if you elect that route.
Self employment is freeing and in some circles, downright coveted. It can be daunting when you are charged with making decisions for the business, your employees, and your mortgage.
If this is your situation, and you’d like to discuss your options, please don’t hesitate to contact me today.