If you’re self-employed and starting to think about buying a home, you might be doing something that will make it extremely difficult to get a home loan. If you’re maximizing deductions to pay less in taxes, you may be costing yourself the chance of homeownership. Keep reading to find out why you might need to rethink your tax deduction strategy before you apply for a home loan.
The Unfortunate Truth
There are a lot of perks that come with being self-employed, and it’s a good thing because there are also a lot of drawbacks. You take all the risk and handle all the stress. You’re not guaranteed a steady paycheck, and the bills never seem to stop coming.
Taxes are an ongoing concern. As a business owner, you pay both self-employment tax and income tax on every penny you make. You’re required to pay the portion of Medicare and Social Security that for most people is covered by their employer.
You make up for the hefty amount Uncle Sam says you owe by taking tax deductions for business expenses. It’s a common practice among the more than 9.6 million self-employed workers in the United States.
A lot of experts say if you work hard enough, you might be able to get to where you don’t show any income at all. If you don’t show income, you avoid paying taxes, which sounds great.
However, if you don’t show income, banks don’t want to loan you money. When you apply for a home loan, you could be denied.
Greg McBride, Bankrate’s chief financial analyst says, “Proof of income is the biggest hurdle that self-employed borrowers encounter during the mortgage application process…Keep in mind that if your business is showing a loss on tax returns, that’s also a loss for loan qualification purposes.”
Martin has a successful plumbing business serving both Laredo and Rio Grande Valley. He’s reliable, trustworthy and his prices are fair, so he’s always busy. In the last few years he hired three more plumbers to help meet the need in his area, and he’s seen business growth.
Like most people, he doesn’t like spending any more than he has to on taxes. From the beginning, he familiarized himself with possible ways to pay less. He deducts things like bank fees, vehicle expenses, employee wages and benefits and equipment. He also takes deductions for his vehicle and his home office. His accountant helps him with bookkeeping, and the accountant’s fees are deductible too.
Plus, last year he bought an excavator to install plumbing for new construction. It was a substantial one-time purchase that provided him with a huge deduction.
Martin has saved over $25,000 to put down on a home. He’s interested in homes in the $200,000 range. He finds one he likes and applies for a mortgage. The bank turns him down.
Last year he made close to $120,000, but with the excavator and his other deductions, he showed no income. On paper, it looks like he only made $35,000 the year before. That’s not enough to qualify for a $200,000 home loan.
Martin isn’t just disappointed, he’s angry. He created his own success by always standing by his word. He has money, a great reputation and a business that will continue to grow. He feels the lender is treating him like someone who can’t manage his money and doesn’t pay his bills.
Why Banks Say No
It’s harder for entrepreneurs to get a home loan, or any other type of loan for that matter, because their income is less predictable than it is for people who punch a clock. Banks rely on check stubs and employment history to verify how much you make and calculate how much home you can afford.
Entrepreneurs don’t usually have those paycheck stubs, so banks ask to see tax returns. They usually want at least two years’ worth, and they use those to figure out the average amount you make per month. Your monthly income decides your debt-to-income ratio and what payment amount you qualify for.
When entrepreneurs take every tax deduction they possibly can with the goal of reducing their taxable income, they seem to make much less than they actually do. You might know a home is well within your budget, but on paper it looks like you don’t make any money.
Lenders want to make sure if they loan the large sum it takes to buy a house, they’ll get paid back. Without income you can’t prove you’re not a bad risk, so they turn you down.
Bad Credit is a Double Whammy
Business owners don’t always take credit as seriously as they should. If you don’t always pay your bills and pay them on time, it will be even harder to qualify for a home loan. If you’re thinking about buying a home, find out your credit score and, if necessary, look for ways to improve it. For that, see our article Why You Need Credit Repair and Where to Get It (FAST!)
How to Get Them to Say Yes
You already have to work harder at everything you do, so it doesn’t seem fair getting a mortgage is harder too. Unfortunately, that’s just the reality. You can make it easier on yourself by starting to prepare early and keeping good documentation.
You’re going to have to pay more in taxes for a few years. Figure out how much home you’re trying to qualify for and allow your tax return to show the net income levels you need to get a mortgage loan for that amount. After write-offs, your income should support a mortgage payment that puts your debt-to-income ratio between 36 and 43 percent.
Reduce your tax deductions and start keeping meticulous records to track income and expenses. Draw a clear line between business and personal expenses. If you’ve been writing off personal spending as a business expense, don’t do it anymore.
Is It Worth It?
When Martin found out what it was going to take to qualify for a home loan, he almost walked away from his dream. If he changed the way he filed his taxes, he would owe more of his hard-earned money, a lot more. It felt worse than wasting money, because when you do that, at least it’s typically on something you want.
He approached the problem like he did most business decisions, with research. Ultimately, he found it made good financial sense to change the way he was filing his taxes so he would be able to qualify for a home loan.
Renting is Better than Buying
Even if you work around the clock, you have to live somewhere. You’ll either pay someone rent or buy a home of your own. Sometimes entrepreneurs look at rising home prices and wonder if there’s enough of a difference between a house payment and the cost of renting to make it worth the extra trouble.
CNBC looked at national trends and found it’s better than to rent than to buy in today’s housing market. In our area cost of living is low, but buying is almost always cheaper than renting.
In Laredo, the average home value is currently $141,400 according to Zillow. With a 30-year note at today’s 3.29 percent interest rate, your mortgage payment would be under $700 a month. You’d also have to factor in insurance, property taxes and in some cases private mortgage insurance (PMI), but with all that, your payment would still be less than $1,000 monthly. Contrast that with the current average rental cost of $1,466.
Rio Grande Valley homes have similar numbers. Plus, the cost of renting is already up three percent over last year and is projected to keep climbing.
In contrast, when you buy a home, you basically lock in the price. No matter how much home values climb, your payment stays about the same.
Your Home Becomes an Asset
When you buy a home, you start building equity. As you pay down your loan, you start to owe less than your home is worth. At the same time, home values go up. Over time, real estate will almost always appreciate.
There aren’t many investments that are pretty much a sure thing. Buying a home is one of the best long-term wealth-building strategies. It makes even more sense for business owners. Your home becomes a valuable asset that if necessary you can borrow against. One day if you need funds to invest back into your business, you can cash in on some of the wealth you’ve built in your home.
Buying a Home Gives Entrepreneurs Tax Benefits
There’s more good news when you own your home. The interest you pay on your mortgage is, in most cases, tax-deductible. For most buyers, in the first years after they make their home purchase, that interest is a significant portion of your payment. If you itemize rather than taking the standard deduction, you can reduce your taxable income by the amount you pay.
Under the Tax Cuts and Jobs Act of 2017, you can also deduct up to $10,000 in property taxes. The same legislation also says if you take out a home equity loan, you can deduct that interest too as long as you follow a few basic rules.
Sometimes when buyers get a mortgage, they pay “points” to the lender that basically buy them a lower interest rate. Points, too, are tax-deductible.
Most lenders require private mortgage insurance if you don’t put 20 percent down when you buy your home. In many situations, you can deduct PMI.
There are also big tax benefits if you decide to sell. With most investments, if you make a profit it counts as income, so you have to pay taxes. If you live in your home for two years, then sell it at a profit, that isn’t the case. According to the home sale exclusion, you’re excluded from having to pay taxes on profits up to $500,000 when filing jointly and $250,000 if you’re single.
Home Office Benefits
Most entrepreneurs don’t stop working when they leave their business location. If you work from home, you can claim part of your space as an expense. There are rules and restrictions, so it’s a good idea to talk to your accountant. However, most entrepreneurs can deduct $5 per square foot for up to 300 square feet, for a deduction of up to $1500.
You can take that deduction whether you rent or own your home, but buying gives your office permanence. You can modify your space to fit your business needs and have a comfortable place to be your most productive without having to consult with a landlord.
Get Help Qualifying for a Home Loan
The mortgage application process is complicated, especially for entrepreneurs. You don’t have to go it alone. The financing experts at WestWind Homes have helped business owners like you repair their credit and gather the documentation they need to qualify for a home loan. Get in touch to schedule a free, confidential consultation with one of our representatives and start working toward homeownership today.