Being self-employed has its downsides and its benefits. Downsides include no paid vacation or holidays and the never-ending need to continually find customers. Benefits include an ability to set your own hours, no limits on your income, and lots of potential business deductions. These deductions can help you save lots of money on your taxes, but they may actually hurt you when it comes time to purchase a home or take out any kind of loan!
Deductions, Deductions, Deductions
If you’ve been a solopreneur for a while, then you are likely a master of the expense deduction. Any time you make a purchase that is relevant to your business, you are allowed to deduct that expense from the income that you show for your business. For example, if you purchase a sleek new printer for $500, you can deduct $500 from your business income*.
The same goes for your cell phone bill, your internet cost, industry tradeshow registration fees, and even the miles you drive in your car to client meetings. A savvy business owner can shave a big percentage of their taxable income just through legitimate deductions.
These deductions will be very good for your tax return, but they could seriously derail your mortgage loan qualification.
Banks Only Care About the Income You Show, Not the Income You Make
When a bank is considering whether or not to offer you a mortgage loan, they will need to determine how much you can afford to pay for your mortgage each month. Several factors affect the equation, including how much debt you have as well as your current asset s. One of the most important factors that will determine how much a bank will lend to you is your monthly income. For example, if you only make $2,000 a month, the bank knows that you probably can’t afford a $500,000 home!
Unfortunately for business owners, the bank doesn’t care how much top-line gross income you earned. They only care about how much net profit your business reported. Maybe you earned $80,000 last year before expenses, but being the deduction genius that you are, you only show net earnings of $40,000. As far as the bank is concerned, you only earned $40,000. They will only qualify you for a mortgage based on that earnings amount, which can dramatically lower the amount of house you can afford.
How to Get a Bigger Mortgage
If you want to qualify for a mortgage that is more in fitting with your $80,000 gross earnings, rather than your $40,000 net earnings, then you’ll have to show higher net earnings. That means you’ll have to take fewer deductions in the years prior to your mortgage loan request.
Doesn’t that mean you’ll have to pay more in taxes?
Yes, it does. In fact, you may even get bumped up into a higher tax bracket. But this one of the primary ways to increase your loan qualification amount. Another way is to work on paying down your existing debt.
Typically, a bank will want to see your tax returns for the prior two years, so you’ll need to switch your expense deduction methods as soon as possible. If you can, figure out your general house price range. Next, determine an approximate monthly mortgage payment for a house at that price (based on the type of mortgage you will seek). You’ll need to show enough income to comfortably make this mortgage payment each month in order to qualify for an adequate loan.
It’s a good idea to speak with a mortgage broker as soon as possible to give you a better idea of what income you’ll need to show in order to get into the house you want.
We can’t emphasize this enough – banks will usually look at your tax filings for the past two years, so start this process early; long before you want to actually buy a house. If you want to buy a house today, but your tax filings show low income, it will be much, much harder (maybe impossible) to qualify for the loan you want.
Sure, you’ll have to pay higher taxes for two years, but as soon as your mortgage loan is approved, you can go back to your normal expense deducting ways!
Want more advice on how to clean up your money act so you can afford a house someday? Consider starting your own Money Club!
*The examples in this article should not be construed as tax advice. We strongly encourage you to work with your accountant to determine appropriate and legal expenses for your business.