- - Thursday, April 19, 2012

Now that their federal income-tax returns for 2011 have been filed, self-employed people, like everyone else, may be breathing a sigh of relief. But if you are self-employed and intend to apply for a mortgage in the next year or two, your tax-related tasks are far from over.

To qualify for a mortgage loan, self-employed borrowers must provide proof of their income in the form of two years of tax returns. In addition, new Federal Housing Administration (FHA) rules require self-employed borrowers to prove their ongoing income in the form of a year-to-date profit-and-loss statement if more than one quarter has passed since their last tax return was filed. In the past, only the tax returns were necessary.

“Self-employed borrowers need to prove their income and prove that they’ve filed and paid their taxes,” said Gail Kullman, a senior loan officer with Prime Lending in Alexandria. “The income is based on the average of the two years of tax returns, but now you also have to have quarterly profit-and-loss statements for the period since you filed your return.”

Self-employed borrowers who work with an accountant easily can supply the requested document, but many self-employed people handle their own accounting and pay quarterly estimated taxes.

Both conventional and FHA lenders will review your two years of income and quarterly profit-and-loss statements to determine whether your income has declined, stayed the same or increased over the previous two years.

“If your income increased by 25 percent or more over the previous year, you’ll need to provide a P&L statement that has been audited,” said Paul Defngin, a senior mortgage banker with Apex Home Loans in Rockville. “If you have a relatively smaller increase in income, you won’t need an audited statement.”

If your income has declined over the previous two years, you may have more trouble qualifying for a home loan because of lenders’ concern that your income will continue to decline to the point that your mortgage is not affordable.

“If your business has declining income, that is a red flag, even if your debt-to-income ratio is currently fine,” Ms. Kullman said. “The lender would need to look at your profession in your area to analyze the strength of your business.”

Marv Stanger, a senior loan officer with George Mason Mortgage in Fairfax, said that while lenders recognize that self-employed borrowers’ income often fluctuates, lenders need to be certain the borrower is managing those fluctuations appropriately.

“If the borrower is barely qualifying and really needs the highest income to qualify for a mortgage, then the lender will be particularly cautious and require accurate, complete financial records,” Mr. Stanger said.

“The borrowers should also be sure they are comfortable with their ability to make their housing payments, so this should be an opportunity to carefully study their budget,” he said. “They should crunch their numbers and make sure they are comfortable with the housing payment and are able to manage the ups and downs of their income.”

One issue that complicates proof of income is that self-employed tax filers typically deduct their legitimate business expenses from their income to reduce their tax liability. Lowering your income to reduce your tax bite may be a great strategy most of the time, but when it comes to applying for a home loan, self-employed borrowers will find that they qualify for a loan based only on their adjusted income, not their total income.

“Self-employed borrowers tend to be liberal with their tax write-offs, which are legitimate, allowable deductions for expenses,” Mr. Defngin said. “The problem for some borrowers is that they cannot then prove that they have sufficient income to qualify for a home loan.”

Mr. Defngin said if self-employed borrowers have significant tax deductions that reduce their income too much, they can opt to eliminate some of those deductions for two years to qualify for a home loan. While few self-employed borrowers are likely to want to pay more in taxes, they have a few other options for financing a home.

“If the self-employed individuals cannot pay cash for a home, another option is to work with a portfolio lender,” Mr. Defngin said. “A portfolio loan for a self-employed borrower with limited provable income will likely require a down payment of 40 percent. Usually these loans are only adjustable-rate mortgages [ARMs] and typically have a slightly higher mortgage rate.”

Ms. Kullman said that self-employed borrowers will find it easier to qualify for a mortgage if they can make a larger down payment because that will reduce the size of the monthly payment and therefore the amount of income required to qualify for the loan.

“Just as it is for any borrower, a higher credit score, a bigger down payment and having extra cash reserves will make someone a better risk for a loan,” Ms. Kullman said.

She said conventional loans require a borrower to have two months of cash reserves, but the cash must be in a personal account rather than a business account. FHA loans do not require cash reserves.

“The more reserves you have, the better,” Mr. Stanger said. “If you have two months, that’s good, but if you have six months of reserves, you are in a stronger tier of borrowers, and if you have one year, you are even stronger.”

Not all lenders automatically consider a self-employed borrower to be a higher-risk loan candidate. If the obstacle of proving income can be overcome, some lenders recognize that self-employed borrowers are less likely to become unemployed because they are unlikely to fire themselves.

If the borrowers can demonstrate that they own a viable, thriving business, obtaining approval for a mortgage loan should be similar to the process for other borrowers.

“If you’re self-employed, you shouldn’t be discouraged from applying for a mortgage,” Ms. Kullman said. “Just make sure you pay your taxes, document your income and have good credit.”

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