Becoming self-employed can be a great career move. However, if you expect to buy a home, refinance or apply for mortgage financing soon, it is important to understand how that change could affect your qualification.
Leaving a salaried or W-2 position does not automatically mean you must wait two years for a mortgage. Lenders do evaluate self-employed income differently, though. As a result, the timing of your employment change can make a significant difference.
If mortgage financing may be in your future, talk with your loan officer before leaving your current job. A short conversation now may prevent a much larger qualification problem later.
How Do Mortgage Lenders Define Self-Employment?
Mortgage guidelines consider your ownership interest in a business and the type of income you receive.
For conventional financing, lenders generally treat borrowers who own 25% or more of a business as self-employed. Business structures may include sole proprietorships, partnerships, LLCs, S corporations and corporations.
Receiving a Form 1099 does not mean every borrower will be treated the same way. Instead, the lender evaluates the employment relationship, ownership interest, income source and applicable loan-program guidelines.
Do You Need Two Years of Self-Employment?
A two-year history is common. It often provides the clearest way to show that self-employed income is stable and likely to continue. Still, not every self-employed borrower must wait two full years before qualifying.
Some conventional guidelines may allow a shorter history when the borrower meets specific requirements. For example, applicable federal tax returns may need to reflect at least 12 months of self-employment. The borrower may also need a suitable prior history of earning income in the same or a similar occupation or field.
Exact requirements depend on the loan program and the borrower’s circumstances. Therefore, it helps to review the situation before making an employment change.
How Is Self-Employed Income Calculated?
Lenders generally cannot use only the money deposited into your bank account or the gross revenue generated by your business.
Instead, they may calculate qualifying income using personal tax returns and, when required, business tax returns. The lender reviews the income and expenses reported on those returns. Then, the lender may make permitted adjustments when calculating qualifying income.
Depending on the business structure, the analysis may include Schedule C income, partnership or S corporation income reported on Schedule K-1, wages paid by a business, and other applicable business income or losses.
Business Income Trends Matter
Lenders look at more than the amount a business earned. They also evaluate whether the income appears stable and likely to continue.
Stable or increasing earnings are generally easier to support than a significant decline. If income has decreased, the lender may need to determine whether the decline has stabilized. The lender must also decide whether the income can reasonably be expected to continue.
Therefore, strong gross revenue does not always translate into strong qualifying income. A borrower may still face challenges if income has declined or business expenses substantially reduce the amount available for mortgage purposes.
Tax Write-Offs Can Affect Mortgage Qualification
Business deductions can reduce taxable income, which may help from a tax perspective. However, lower taxable business income can also reduce the income available to qualify for a mortgage.
Mortgage guidelines permit certain adjustments and add-backs when lenders analyze tax returns. Therefore, taxable income is not always the same as qualifying income. Even so, substantial business deductions can sometimes reduce mortgage borrowing capacity.
Your CPA or tax professional should advise you about tax strategy. Meanwhile, your loan officer can explain how a lender may analyze the income reported on your returns.
Will the Lender Need Business Tax Returns?
Possibly. Documentation requirements depend on the loan program, business structure, ownership percentage, time in business and how the income is reported.
Some borrowers may qualify with fewer years of tax documents when they meet specific guideline requirements. Other situations require personal and business returns, along with additional documentation.
The lender may also need current business information. This helps confirm that the business continues to operate and that its income remains stable.
What If You Are Thinking About Leaving a W-2 Job?
This is where planning can make a major difference.
You may currently qualify for a mortgage using W-2 income. However, that income may be evaluated differently if you leave the position to start a business, become an independent contractor or acquire significant ownership in a company.
Becoming self-employed is not necessarily a bad decision. You simply need to understand the possible mortgage consequences before making the change.
If you may buy a home, refinance, obtain a home equity loan or make another major financing decision soon, speak with a loan officer before changing your employment structure.
Planning Ahead Can Save You Problems Later
I have worked with self-employed borrowers throughout Maryland, Washington DC and Virginia for more than 20 years. These loans are often manageable when we understand the business, income history and documentation before the mortgage process begins.
If you are considering self-employment and expect to need mortgage financing, contact me. We can review how the change may affect your qualification before you make the move.
Ready to explore your options? Start your prequalification online.
Mortgage income and documentation requirements vary by loan program, lender, business structure and individual circumstances. They are also subject to change. This information is for general educational purposes and is not a commitment to lend. Consult a qualified tax professional regarding tax planning or tax advice.
