The tax write-offs for being self-employed help save a ton of money when filing income taxes; however, those write-offs may not be so great when qualifying for a home loan. Simple said: when getting a mortgage the qualifying income is determined by the money you pay taxes on. If you don’t pay taxes on it then chances are we can’t use it. By having those tax write-offs you’re telling Uncle Sam that you need to spend that money and incur those expenses in order for your business to make the money it does and therefore can’t be considered for Qualifying Income and increases the Debt To Income. Check out our Debt To Income Calculator to see the impact of qualifying income.
Sole Proprietor Income
Below is an example of how income is calculated for Sole Proprietors filing on the Schedule C of a tax return. Please note that this is an over-simplification of the process and shouldn’t be used as tax advice or as a way of suggesting how to qualify for a home loan. The actual determination on what can be considered qualifying income is slightly more complicated and won’t be covered here; however, the information below provides a solid foundation on what the mortgage industry does for Sole Proprietor income.
Average vs. Most Recent Year
The basic rule of thumb for using self-employment income is to use the past two year’s of tax returns and then take the average of both year’s; however, this isn’t always the case. The real “trick” to determining the income is knowing what year’s income to use. If the income was consistent for the past two year’s, or has been increasing, just use the average of the past two years. If the income is declining (i.e. the income of the most recent year is lower of that from the previous year) then use the lower, most recent year’s income.
Calculating Schedule C Income
The formula is relatively simple – you start with the net profit (or less) and then add-back a few items and subtract meals and entertainment. If the net income is a loss then that number will be a negative and it’s absolutely possible that you can end up with a negative qualifying income depending on the total expenses on line 28.
Net Profit (or Loss) (Line 31)
+ Plus Depletion (Line 12)
+ Plus Depreciation (Line 13)
– Minus Meals & Entertainment (Line 24B)
+ Plus Business Use of Home (Line 30)
= Qualifying Income
Once you have this final figure you can then Calculate Your Debt To Income (DTI). As always, please call us if you have any questions as we’re here to help and we’ll be happy to run the calculations to determine your qualifying income.
Profit and Loss Statement
A Profit and Loss Statement (P&L – pronounced “P and L”) may be required if you’re self-employed and have not yet filed your tax returns for the previous year. This doesn’t happen often but could be required substantiate a trend in a business’s growth pattern and help us determine your Qualifying Income.
Loan Officer, NMLS # 729612