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Self-Employed? The Mortgage Rule You Need to Know

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When applying for a mortgage, lenders will classify you as a wage earner employee or self-employed. Furthermore, if you also own a business, or a percentage of a business, you might be considered self-employed even though you are a W-2 wage earner. If this is you, here’s what you’ll need to know to complete a mortgage application.

To start with, here are the income classifications for lending:

  • Employee: Individuals are W-2 wage earners and receive a paycheck. From the paycheck, taxes are withheld.
  • Self-employed: This includes everything else — a sole proprietorship, any business entity where income is derived or lost (including all affiliated corporations), income derived from real estate and dividend income are all included in the self-employed bucket.

Where the Two Worlds Intersect

Bona fide employees who also have an ownership interest in the company can actually be considered self-employed. For example, if you’re a W-2 wage earner employee and you have an ownership interest in the company that employs you – and the interest is more than 25% of the business, this would earmark you as ‘self-employed’ for the purposes of completing a mortgage application. If you happen to be a W-2 wage earner, but you have a percentage of ownership in another business, you would be considered both an employee and self-employed.

Business Ownership & Getting a Home Loan

Your federal income tax returns are required for the purposes of documenting ability to repay in securing a new mortgage. On your tax returns, as a sole proprietor you file a Schedule C, and this income carries over to Schedule A. Most sole proprietors don’t have separate business entities, so corporate returns are not required as it is 100% ownership. However, things are different when you have an ownership interest in a company.

  1. Schedule E identifies whether or not there is additional business income and/or that you are an owner in an additional business.
  2. If an additional business is present on the return, the mortgage lender will require a K-1 to determine the amount of percentage of ownership.

Mortgage Tip: If you own 24% of a business, you are not considered self-employed for the purposes of the loan application, and the lender will not need to obtain the corporate income tax returns. However, if you own 25% or more of a business – whether it’s your current employer or another business entity, as identified on the K-1 – then, yes, you’ll need to provide additional income tax returns for the entity in addition to your personal tax returns for obtaining the mortgage.

Why All Income Examination Matters

An ability to repay analysis is required on all mortgage loans. Simply providing W-2s, pay stubs and personal tax returns is not enough if you have more than a 25% business ownership interest in another company. If you’re receiving additional income from another business, and that income is tied to your personal tax returns necessary for securing that mortgage, it becomes necessary for the lender to need the additional tax returns because it supports your income and subsequent ability to repay. Lenders are required to average your income in most cases during the past 24 months (including the business income) and that averaged income or loss will be used on the application in accordance with obtaining the new mortgage.

A financial word to the wise for the self-employed: By virtue of having an ownership interest in a company, you don’t need to provide the additional tax returns if you are a small minority share owner.

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  • ScottSheldonLoans

    Brad I am bit late on the uptake here, my bad. Glad you enjoyed the article thanks!

    • jen

      What is the seasoning for the 24% maybe he can change his taxes ti comply to be considered not self employed

      • ScottSheldonLoans

        That’s a great CPA question.

  • ScottSheldonLoans

    I am trying to make sense of this question. From what I can gather, you have both corporate and personal tax returns. You cannot pick and choose so to speak which income a lender will or will not use. The K-1 would be revealed on the 1040 despite being w2ed, causing the need for the rest of the returns, including the corporate returns for the last 24 months. Providing that would assist the lender in helping you qualify. Lenders want to make loans, but they also need to be cautious when calculating income figures for a self employed borrower.

    • rogue_121

      Right, but after I posted this I found a guide on Freddie’s site about what they look for when buying loans. One of the items mentioned under the self employed section on page 8 of this document stated the following: “If the borrower is self-employed and the self-employment income is not used to qualify [something else is used, then?], the Seller must obtain the borrower’s individual federal tax returns to determine if there is a business loss [via Schedule E, included on a personal tax return, I presume] that may have an impact on the stable monthly income used for qualifying [in this case, regular W2s]. If a business loss is reported on the borrower’s individual federal tax returns [There never has been one, while very small the number has never been negative], the Seller may need to obtain additional documentation in order to fully evaluate the impact of a business loss on the income used for qualifying.”

      Considering wanting to not have that income used and only W2 income considered and the fact an underwriter would have access to the Schedule E which is included on an individual’s tax return, does it not make sense that so as long as they can tell there are not losses on schedule E that negatively impact the solid W2 income that they don’t worry about that business? It’s a bit like buying shares in Walmart and making $20K a year in dividends, for example. Then you work at Walmart as a Cashier and get a W2. Even if in theory you owned 25% or more of that company somehow, the two are not related. Since the underwriter can tell that you have at least not taken a loss from your ownership, I’m gathering from the above quoted that you simply could not worry about it since there is qualifying income elsewhere on the tax return more than sufficient to cover the loan with a solid DTI.

      Link for reference: http://www.freddiemac.com/learn/pdfs/uw/docmatrix.pdf

      • ScottSheldonLoans

        W2 income can be used without needing the corporate returns if you have a less than 25 ownership, like 24.99%. You are considered self employed even if you are w2ed if you own 25% or more of a business then k1’s and corporate returns are needed. It is that black and white. The only reason I could guess why a borrower wouldn’t want to show corporate returns is that they are running the company dry to themselves a salary. If not, then there shouldn’t be anything to hide, despite how inconvenient it is providing the additional paperwork. Hope this helps.

        • V

          Scott, what is the answer when the business is a C corp, not an S, or partnership? Are K-1’s required of a C corp for more than 25% ownership in the company, despite being W2’d and not receiving any dividends? The other owners are ‘angel’ investors who are likewise not receiving any dividends.

          Thanks for additional light you could shed on this topic. It’s hanging up our refinance!

    • rogue_121

      I guess my main thing is that I am amazed that because of the fact that I own exactly 25% I must show all of that information, even though I don’t need it and it doesn’t make up more than probably .01% of my income, if even that. Since there are other parties involved, it makes even more hassle because I have to go through them to even get access to this information. Because of this hassle, it literally makes you wish you owned 24.99%! Any of our employees that work for the same company are pretty much on the same level as I would be; outside of salaries there have not been any profits to speak of! However they are approved on those same W2s without the blink of an eye. I must admit that I am starting to agree with those who say we have gone too far to the other side of the range on this because of the crisis and I can see where folks would believe fraud to be on the rise! Thank you for your input and wisdom on this!

  • B

    What are the rules for a C Corporation ? There are no “forms” attached to a personal income tax return. How does this play into qualifying for a mortgage.

    • ScottSheldonLoans

      Not sure I totally understand your question–please clarify what you are asking.

      • K

        “B”‘s point is that shareholders of a C corp do not need to count the company’s income/loss into his or her personal income tax; while those who of an S corp do need to pass the company’s income/loss to his or her personal income tax. Now how would a C corp owner (>25%) be treated in mortgage application? Although it makes sense that for an S corp owner, the company’s income needs to be reviewed by the lender.

  • ScottSheldonLoans

    Contact me and I may have a solution. without knowing all the ins and outs, any answer here would most likely be wrong as this is incredibly technical and would need to be deciphered by a lender who can look at your complete financials. Generally speaking in situations like this, loss of business income can offset W-2 income and you can’t pick and choose what income the lender uses to qualify.

  • R

    I have a client who is purchasing a home and is currently in the second underwriting phase. The lender is asking her to provide corporate tax return for a small investment club that she is part of. There a four people in the club. My client files the K1 with her individual tax returns and each of the four members have do the same thing. They have never filed a corporate/ business tax return. The amount of income she receives is minimal and probably is not sufficient enough to be included in her ability to pay back the loan. My client is retired, has sufficient income from her retirement and is putting down over 50% of purchase price. My questions are , is she considered self employed? If she has never filed a corporate tax return(only individual) what is the alternative for my client and the lender asking for documentation that does not exist?

    • ScottSheldonLoans

      There is no offset to this. If she has k-1’s then she probably has or can get access to the partnership return. The down payment is insigificant. All income identified on tax returns is questioned & documented whether is used in the qualifying or not.The income source can be cherry picked, sorry, but your client will likely need to provide the k1s & supporting returns that accompany those documents.

  • Kalen Raynor

    My husband and I both own our own companies. I have our tax returns. When looking at them how do I determine what our income is in regards to qualifying for a mortgage. Is it pre- deductions or after?

    • ScottSheldonLoans

      Hi Kalen,
      It’s after tax…but not that blanket. What kind of returns are we talking about? Let us know so I can better answer your question.

  • Truth

    Would the one year schedule c income from 2014 tax returns and p&l from 2015 work? can this income be used?

    • ScottSheldonLoans

      Generally not anymore. You need to provide two years of tax returns and the two years of tax returns income will be used to qualify. A profit and loss statement is not to show higher income for qualifying. The purpose of the profit and loss statement is to show that the current income is consistent with the most recent years income tax return. Sorry to bring you the bad news. The offset to this might be putting more money down or paying off debt to qualify both of which,could be viable options in your scenario.

  • Ron Rodgers

    Can my underwriter ask to see my corporate bank statements that do not directly relate to my claimed income as the borrower. I.E.. I explained my w2 wages and documented a check the corporation paid me back for a loan I gave it when it started 5 years ago. Now the want 3 months of all corporate bank statements. Is that even legal to ask me ? There is all kinds of corporate transactions with employees and vendor info that has nothing to do with me or my stated income. Can they ask for this ??

    • ScottSheldonLoans

      Yes a bank can ask for any form of documentation to support income. Nothing illegal about asking to provide documentation for a mortgage. You did raise a red flag you mentioned stated income? Generally, if there is anything related to the corporate entity on your tax return it is up for grabs for the underwriter -that is the simple way to look at it. I would just go ahead and provide the documentation as it will probably get you an answer quicker and than resisting it.

  • Alan

    Hi Scott.

    Excellent article that sheds some light on why this documentation is so important.

    A quick question for you — I am tasked with proving less than 25% ownership of a California C-Corp that contributes a really insignificant (0.001%) portion of my income by underwriters.

    The company produces nearly 0 in income and has never issued a K-1 in its life. What I do have however is photo copies of the original stock certificates issued from 2004 which clearly show that I do not own more than 25% (in fact less than 10%). Should or would this sufficiently satisfy underwriters?

    If not, I don’t know what else to do as there is no one really piloting the ship any longer, there are no assets or income to produce any other paperwork for me, and there is virtually no one to contact for further information. I have no financial control of the company.

    • ScottSheldonLoans

      Alan-will do my best to answer this question, although it might not be the answer you’re looking for. If you have multiple businesses, this condition could come up if you or otherwise self-employed. In other words if your income is 100% self-employed income then yes it would be reasonable for the underwriter to ask this question as income is caring over to your personal tax return. I would also write a letter of explanation detailing, there is no more assets in the company more income and is essentially void. Another way to possibly fulfill the condition is to simply close the business and its entirety burying any questions or further underwriting conditions.

  • Corey Haggard

    I am applying for a home loan. I am employed by the company as a w2 employee, however I have a 50% ownership of the LLC. Will the bank be able to use my self employment income filed on my schedule E in conjunction with my w2 from the same company?

    • http://blog.credit.com/ Kali Geldis

      Hi Corey —

      The mortgage loan officer at your bank or credit union will be able to help you with income questions for qualification purposes. As the article states, you would be considered “self-employed” because of your interest in the company.

  • fascinero

    So if someone has 30 years of consistent self-employment, and has a lot of cash and no debt, … but if they decide to take a year off and go do charity work, …then that means they can’t get a mortgage based on their ordinary yearly income? Wow. This will hurt the ability of doctors to get mortgages who not only have good income and often are cash rich but also do charity work from time-to-time.

    I just finished a couple years of charity work, working in a free clinic for which I was drawing down savings, have not carried debt for 25 years, have strong cash reserves, and now am back at work making over 6 figures, ….but I can’t get a mortgage.

    And yes, I know it’s late, but I *am* a first time buyer. Most of my cash is in retirement accounts, so I`d prefer not to take the tax penalty for liquidating retirement plans early in order to buy my first home. What options do I have other than wait two more years for a meaningless history to build up? And yes, I believe the history is meaningless because by definition a mortgage can only be paid with future income…everything else is a down payment.

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