How to Buy a Home When You're Self-Employed

Since the inception of qualified mortgages this year, the process to successfully close on a mortgage has become compliant-heavy by industry standards. This is especially true if you own your business.

It’s no mystery among self-employed borrowers that banks do not make it easy for an entrepreneur to qualify. Here’s what you’ll need to get approved for a mortgage.

Tax Returns

Plan on providing your lender the most recent two years’ federal tax returns. Two years of tax returns is the industry norm with most banks and lenders — or a copy of the most recent year’s filed IRS extension if your taxes are not yet completed.

When you supply your tax returns, it’s crucial to know that lenders will only use your IRS-validated tax returns to calculate your income. If the tax return is filed, but not validated by IRS, in most cases, your loan will be held up until the IRS actually signs off on it.

Lenders will average your income from the last 24 months, despite a good or a bad year. In most cases, you’ll be hard-pressed to have a lender ignore a tax return in light of the more favorable year’s higher income figures.

If you’re applying for a mortgage loan now, you’ll need to provide 2011 and 2012 returns, and a copy of the IRS filed 2013 extension. Let’s say your income in 2011 is low; the lender will still use this income if they have not received the validated 2013 return. When the 2013 return validation comes in, 2011 can be omitted from the picture, as 2013 and 2012 validated returns meet the two-year requirement.

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Year-to-Date Profit & Loss Statement

A year-to-date profit and loss statement supports a continuation of income, especially in the circumstance of one year’s income being higher or lower than the other. Let’s say 2012’s income was more than 2013, the lender is going to request a 30-day profit and loss statement to support your current income. This action addresses any possible concerns about declining income, which is a risk characteristic lenders look for when making a sound loan approval.

Business Funds

If any of the funds used for the loan — including cash to close, down payment or reserves (money in savings) — are primarily used in connection with the operation of your business, the lender will scrutinize the funds more closely.

Here’s why: A reasonable assessment could be made that repositioning funds out of the business for use in another endeavor (like procuring a home loan) could impact the future viability of that business, moreover the sustainability of the revenue the business generates. Providing a third-party validation of the use of these funds omits the risk test. This can be accomplished by a bookkeeper or accountant simply validating that the use of business funds shouldn’t impact the viability of the business. (Tip: You’ll have an easier time using business assets for reserves, rather than cold hard cash from your business account.)

How to Calculate Your Income

Expect the lender to use a 24-month average of your income if your business has been in existence for the past 24 months. However, if your business has only been in existence for the most recent 12 months, you can still potentially qualify for a mortgage without the two years of tax returns. You will need six months of self-employment income identified on a validated tax return when your business has been around for less than two years.

Lenders use the following when calculating a self-employed consumer’s income:

Net profit
Business use of the home (if applicable)
Depletion
Depreciation

How it all comes together:

Take net income
Add business use of the home
Add depletion
Add depreciation

Do this for each year’s income tax return and simply divide by 24. This is the average income lenders will use when qualifying you for a mortgage. It doesn’t matter whether you’re purchasing a home or refinancing a home, the income is calculated the same.

Additionally, self-employed borrowers showing strong home-equity, excellent credit, millions of dollars in the bank and further supporting creditworthiness will still need to show income. In this compliance-focused world of home lending, proof of income is — and remains — king.

[Editor’s note: Before you search for a home, it’s important to be familiar with your credit standing, and be sure there are no items on your credit reports that could stand in the way of you getting a home. Check your free annual credit reports for any errors or fraudulent accounts that could be a drag on your scores. You can also monitor your credit scores for free through Credit.com, and get an analysis of your credit along with a personalized action plan to help you meet your credit goals.]