Understanding What Mortgage Lenders Look For On Your Tax Returns

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If you are like most business owners, You are probably thinking, why not reach out to my business bank and skip all the shopping around for a loan?  They know me; they take my checks every week that I deposit.  They will give me a loan.

Well, I know firsthand (as a business owner) you miss out on some of the best options that you have, and you will leave a lot on the table, possibly even giving up on the dream of owning that home you have your eye on.

As a self-employed homebuyer, you have a unique opportunity that many other prospective homeowners don’t—the chance to increase your chances of getting approved for mortgage financing. 

When lenders look at mortgage applications from customers like you, who are self-employed, they take extra care to make sure the information on your tax return is correct. 

So what do these mortgage lenders look for on your tax returns? And why does it matter? Let’s explore further so you can get armed with the information necessary to successfully apply for – and secure – a loan with the best terms and conditions.

Understanding Underwriters’ Reliance on Tax Returns

Mortgage lenders heavily rely on tax returns when underwriting applications, as they provide lenders with critical information about a borrower’s financial health. For self-employed borrowers, this is especially important as they are required to report both business and personal income on their returns. On the other hand, when underwriting borrowers who are employees of a company, there may be less need to cross reference tax returns due to the fact that their salary is consistent and reported directly by their employer. Nevertheless, tax returns are still requested for even these employee-borrowers in order to verify their reported income. Therefore, it can be concluded that underwriters always rely on tax returns for a complete picture of the borrower, regardless of whether they are a business owner or an employee.

Personal vs. Business Tax Returns: What Do They Need?

Underwriters play a critical role in the home loan application process by ensuring borrowers have the financial means to repay their loans. Therefore, they take into account both personal and business tax returns when assessing an individual’s overall financial situation and creditworthiness. They usually will require applicants to include two years of tax returns to ensure that their accounts are up to date and only review the business tax returns if the borrower has more than 25% ownership. Through a thorough review of both types of taxes, underwriters can identify any discrepancies in past debts or income levels revealed in present-day records. This provides an essential insight into developing a detailed picture of a borrower’s financial stability, thus contributing to informed judgment regarding loan approval decisions.

IRS Verification: The Role of Tax Transcripts

Underwriters verify borrower sources of income when processing a loan application by obtaining tax transcripts from the Internal Revenue Service. Tax transcripts include information about sources of income reported on a given tax return, such as wages, tips, self-employment income, and retirement sources. Underwriters use tax transcripts to validate the sources of income reported along with other verification activities that may be conducted, like running credit checks or requesting financial documents. This process is used to ensure the accuracy of information provided on loan applications and to determine whether borrowers have sufficient sources of income to make payments on a loan.

Key Factors Mortgage Lenders Look For On Your Tax Returns

As a small business owner, you know that when it comes to getting a mortgage, lenders, and underwriters pay close attention to your tax returns. Gross self-employed income is not the same as taxable income. Your gross income may be much higher than what you’re actually able to use for loan programs due to write-offs and other potential deductions. Deductions such as self-employment taxes, health insurance premiums, mileage, and home office expenses can significantly reduce the amount of money available for purchasing a home. Understanding these differences is important so you can accurately figure out what loan programs are best for your situation.

How are they calculating your income?

When a self-employed individual is applying for a loan, lenders typically need personal, and business tax returns to calculate the borrower’s income. Personal tax returns allow them to evaluate the individual’s personal assets, income, and expenses, while business tax returns show their business’s gross income versus net income. By utilizing personal and business tax returns, lenders are able to gain an understanding of how much net profits are available when determining the self-employed borrower’s earnings potential.

What if Newly Self-Employed?

For those of you who have recently made the transition over to becoming your own boss, you are probably wondering where this leaves you.  You most likely don’t have two years of tax returns and possibly have not even filed one yet!  Can you even get a mortgage at this point?  

The answer is not black and white when it comes to qualifying for a mortgage loan when you are newly self-employed. However, what I can assure you is that you will not qualify for a traditional mortgage because almost every single one wants tax returns.  The only way to work around this rule is to find a co-signer that is willing to go on the loan with you and use an FHA or Conventional loan. 

If that isn’t an option, there are new Non-QM loans that do not require 2 years and even 1 year of tax returns.  Many of these loan programs do want to see that you have lasted two years on your own.

Ex.  You became self-employed in February of 2021 and filed one year of tax returns.  It is now February of 2023, but you don’t have 2022 taxes yet.  You would be eligible for a self-employed loan and meet the two-year requirement.  

There are also a few non-QM loans that, if you remained in the same line of work, are a sole proprietor, and are now receiving 1099 income, compared to the W2 income you received in the past, there are a few programs that will qualify you off of your 1099 statements that you get at the end of the year.

These loan programs will require more of a down payment and are not as lenient as the government-backed loans you have heard about, but they are an option that can get you into a house.

What to do if you don’t qualify for the home or price range 

If you find yourself not qualified for a loan at this time due to your self-employed income, there are options to consider. One approach would be to wait and file another tax return as proof of income. You could also look into amending earlier tax returns in order to further prove the consistency of your income. Additionally, loan programs designed explicitly for loan borrowers who can show long histories of self-employed income may be available; speaking with a loan officer could shed light on what loan products are available. As a loan borrower, it is essential that you have all necessary documents showing proof of consistent and sufficient income – these will be required when applying for a loan program geared towards self-employed borrowers.

Actions to take to help you qualify in the future 

The number one piece of advice I give every business owner that we work with is to educate yourself on how to review and read your tax returns.  Even if you aren’t looking for a mortgage anytime soon, you will save yourself more money and time by being able to read your tax returns.  Remember that your accountant or CPA is human, and humans make mistakes.  No one is going to care about the taxes you pay more than you do.  

Over the past 5 years, I have caught and questioned my accountants three out of the five years, and after discussions and review, every single return was updated and corrected to reflect what really happened and should be on the returns.  These mistakes and misunderstandings would have cost me over $50,000 in taxes to Uncle Sam, something I try to keep at a minimum every year.

My top 3 Tips to help when applying for a mortgage are:

• Do not mix personal and business expenses and bank accounts – this is especially common with sole proprietors and specific lines of work.  Let’s use real estate agents as an example.  There are a few simple steps you can follow that will give you a much better chance at qualifying for a conforming loan when the time comes.
  • Open a separate business bank account – deposit all of your real estate commission checks into this bank account.  Pay your business expenses out of the business account and transfer money into your personal account after the business expenses have been paid.  Doing this will give you the ability to exclude any payments, such as a car payment if you can prove that the car was paid for a minimum of 12 months out of the business account.
  • Designate one credit card for business expenses and pay the credit card out of the business account.
• Get involved with the process of preparing your tax returns- do not leave all of the decision-making up to your tax preparer.  They do not know your business the way that you do. If you are in the habit yearly of sending your CPA all of your bank statements and credit card statements for them to sort and organize, you are going to miss writing off expenses that could otherwise have reduced your tax liability.

• Get comfortable with non-QM loans or be ok paying more in taxes- Most self-employed homebuyers try to stay away from non-QM loans because the interest rate is higher than on conforming loans.  This is a big mistake!  Yes, the interest rate is higher on these mortgages, but the total interest paid in one year does not come close to the amount you will pay in taxes if you choose instead not to deduct all of the expenses you are eligible for.

“Mortgage Lenders that do not require tax returns”

Self-employed borrowers have access to bank statement loans, also known as non-QM (non-qualified mortgage) mortgages, that do not require tax returns and instead qualify the borrower based on bank deposits, P&L statements, and a few other key indicators. These bank statement loans offer convenience for self-employed borrowers, but it is important to note that they often come at a higher interest rate than would be found with a traditional loan type. Nonetheless, bank statement loans provide an additional margin for those who don’t qualify for conventional mortgages but still need financing.

Unfiled tax returns

Although good credit is a significant factor in obtaining traditional mortgage financing, other potential roadblocks could impede the process. The presence of unfiled tax returns or any unresolved outstanding income taxes may prevent borrowers from being eligible for conventional mortgages. 

In these cases, filing the necessary tax returns and paying off any outstanding revenue due to the IRS can help borrowers boost their chances of being approved. However, pending additional documentation, such as a payment plan from the IRS, might be a good idea if filing unpaid tax documents is not an option. If a borrower does not secure conventional financing, non-QM loans may provide them with an alternative source for securing a mortgage loan.

When self-employed individuals apply for a loan, lenders will ask for more paperwork than those with traditional employer income. They must not only calculate income and assets but also debt in order to determine the loan amount and interest rate. If an individual doesn’t qualify for a loan, they should consult an expert, such as a mortgage broker or a financial advisor, about their options. Some websites, such as Selfresource have resources to help fill in any missing gaps hindering your loan approval.  The process of obtaining a mortgage loan can be complicated, even when self-employed. However, it is doable if you have enough preparation. Don’t give up, and plan ahead if you want a better chance at being approved. Taking the initiative and being prepared can mean the difference between being denied or approved for a loan. What hurdles have you had trying to get a loan? Let me know in the comments – I’d love to hear your stories!

Terms to Know if Self Employed

AGI- Adjusted Gross Income– Adjusted Gross Income (AGI) is defined as gross income minus adjustments to income. Gross income includes your wages, dividends, capital gains, business income, retirement distributions, and other income. Adjustments to Income include such items as Educator expenses, Student loan interest, Alimony payments, or contributions to a retirement account. Your AGI will never be more than your Gross Total Income on your return and, in some cases, may be lower. Refer to the 1040 instructions (Schedule 1)PDF for more information.

Schedule C– Use Schedule C (Form 1040) to report income or (loss) from a business you operated or a profession you practiced as a sole proprietor. An activity qualifies as a business if your primary purpose for engaging in the activity is for income or profit and you are involved in the activity with continuity and regularity.

Schedule E- Use Schedule E (Form 1040) to report income or loss from rental real estate, royalties, partnerships, S corporations, estates, trusts, and residual interests in real estate mortgage investment conduits (REMICs)

Depreciation– a reduction in the value of an asset with the passage of time, due in particular to wear and tear

Partnership- A partnership is a relationship between two or more people to do trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business.

S Corporation- S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.

To qualify for S corporation status, the corporation must meet the following requirements:

• Be a domestic corporation
• Have only allowable shareholders
  • May be individuals, certain trusts, and estates 
  • May not be partnerships, corporations, or non-resident alien shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic, and international sales corporations).

C Corporation- A C corporation (or C-corp) is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. C corporations, the most prevalent of corporations, are also subject to corporate income taxation. The taxing of profits from the business is at both corporate and personal levels, creating a double taxation situation.

K1’s- Schedule K-1 is a federal tax document used to report the income, losses, and dividends for a business or financial entity’s partners or an S corporation’s shareholders. The K-1 form is also used to report income distributions from trusts and estates to beneficiaries.

A Schedule K-1 document is prepared for each relevant individual (partner, shareholder, or beneficiary). A partnership then files Form 1065, the partnership tax return that contains the activity on each partner’s K-1. An S corporation reports activity on Form 1120-S. Trusts and estates report the K-1 form activity on Form 1041.