Home : Blogs : GLENN LEACH : GLENN's Blog

Self-Employed and Tax-Returns...

red light camera One of the biggest casualties of the current tightening of mortgage guidelines has been Self-Employed Borrowers. This month, I've had two applications that I've had to turn down for lack of income even though each of these applicants was generating thousands of dollars in "revenue" each month. The reason the applications were turned down was because too much of their income was written off on their tax returns.

Even though the write-off's were a legitimate and legal way to reduce their tax liabilities, they also left too little bottom-line income to qualify for a mortgage loan. In the past, these applicants' loans would have been approved using one of the less-stringent loan programs. But today those "less-stringent" programs no longer exist - so these folks can't qualify for a mortgage anymore.

You may insert your own personal value judgment here about whether this is good or bad for our economy or the housing markets and whether it is fair or unfair. I mention it because it is a major change in lending and self-employed borrowers need to be aware that if they are trying to buy a home in the future, they will need to prove 2 years' worth of satisfactory "bottom-line" income to qualify.

But rumors circulating around right now also raise another concern for self-employed borrowers:

With the government buying up massive amounts of mortgage loans through Fannie Mae & Freddie Mac purchases - funded by the recent "Stimulus" packages - word is that the IRS (another arm of the government) is starting to compare the loan applicant information with tax return information. Until recently, Fannie & Freddie were not government-run organizations, but now that they ARE, will they be freely sharing data with the IRS?

"How can you afford to pay a mortgage payment that is higher than your income?"

Let's say your loan was purchased by Fannie Mae and your mortgage payment is $3,000 a month. What happens if the IRS cross-references your tax return info with your loan application info and discovers that, after all your write off's, you are claiming less than $3,000 a month in income? The logical question is then, "How can you afford to pay a mortgage payment that is higher than your income?" Will this trigger an Audit? Many insiders are suggesting that soon it will.

Is this a bad thing for the IRS to do? Probably not. This could be an effective way for them to root out tax cheats, under-the-table earners who aren't paying their fair share of taxes, and even possibly find terrorists and drug dealers. But it will also cause extra hardship on individuals who have lost their jobs or their businesses are down and they have been making their payments from savings.

In reality, if this policy does go into affect, it'll probably be like them red light runner ticket cameras: If you're not running red lights, you have nothing to worry about, but I can't help feeling like my privacy is being invaded every time I drive through those intersections.

Posted by GLENN LEACH on 09/11/2009 11:40 AM

Comments (67)

Tax Returns in the ActiveRain Channel

Post is included in group: The Art Of Marketing You
Post is included in group: Realtors®
Post is included in group: Puget Sound - WA Real Estate
Post is included in group: All About Mortgages/Mortgage Networking
Post is included in group: 1st Time Buyers

67 Comments on Self-Employed and Tax-Returns...

SEP

A thought-provoking post! Sounds like it's time for a flat-rate income tax to be fair to the self-employed.

This is especially true for us agents as we have so many write-offs!

Hi Glenn -- Very intriguing post. While in theory, it should be easy to cross-reference, I have doubts about the abilities of our federal government to do a stellar job.

I think the issue of employed individuals who are judged on GROSS INCOME, versus self-employed individuals who are judged on NET INCOME, after LEGITIMATELY WRITING OFF BUSINESS EXPENSES needs to be addressed. I recall someone on this forum a long time ago, making a disparaging remark about self-employed people "penciling out" write-offs, as if they were trying to scam someone, when in reality, smart business people wriite off every expense they are entitled to write off.

Interesting post and possible consequence of further government interference control. The write offs may be legitimate for things like health insurance and car payments, etc. that are allowable for the self employed.

I guess I fall into the category of "Fringe Conspiricist" if that's a word. I think in the age of big, organized labor movements giving huge donations and endorsements to certain political agendas, the efforts of individual, self-employed independent thinkers are a threat. We can expect LOTS WORSE stuff coming down the pipeline for us as far as the IRS is concerned. Buckle Up! Gonna Be A Rough Ride for a few years......

Glenn -

This could be a very big problem, especially, short-term, for the rate resets of self-employed individuals.

A new group to pick on, I guess - we self-employed folks who have had to endure quite a hit in the last couple of years. However, the regularly-employed will shed not a tear, I would imagine.

And that includes the IRS Auditors!

I guess we'll have to pay the IRS money we do not have! What a fine economic stimulus!

DEAN & DEAN'S TEAM CHICAGO

There has to be an alternative for the self employed. I may be wrong but a growing number of Americans are self employed. Something has to give.

Good for the banks and the IRS. If self employed people aren't paying their fair share of taxes then those of us who do are paying more then their fair share. If they can afford a mortgage payment they can afford to pay their share of taxes. I'm sorry but I have no empathy for those who write off all their income and then expect to qualify for a mortgage payment. Legitimate write offs are fine but if they are not showing income to qualify but yet have money and income to pay a mortgage something is fishy.

Glen: Self employed borrowers have to prove so much more and as you say the guidelines are much tighter. Stated income and no asset loans are a thing of the past.

Hi Glenn. Many of us are self-employed who pay our fair share of taxes. It affects some of us too.

SEP

Hmmm I never really thought about it like that! It is true that self employed borrowers are tough to qualify... but they can be done if you go through their tax return with a fine tooth comb. There are many deductions that can be added back in.

That's really sad to me. It seems like we are caught between a rock and a hard place. No one wants to pay more taxes than absolutely necessary, but we also need to be able to obtain a loan!

Bottom line: If you wrote it off..... It SHOULD be legal/legitimate. And if you DID write off legitimate business expense.... Then you really didn't make all of those thousands per month.

Whether it is an FHA loan or a Fannie/Freddie loan.... The government is basically backing you.

You CANNOT tell the irs that you make $2000 per month and your lender that you make $8000 per month. Not anymore!!!!!

Want to buy a home? Pay your taxes!! ALL of your taxes.

I don't know that would raise IRS read flags because you still have to report the deductions and if they are legitimate its OK. However, it would be a problem getting a mortgage now that stated income loans are pretty much non existant.

All of us realtors are in this situation in that we have large expense writeoffs including depreciation for office equipment, cars, etc.

It is a catch 22. The more you write off the less mortgage you qualify for. Again another great argument to throw the whole income tax system in the trash and implement a national sales tax.

Ahhh... The debate is on. Is this Big Brother watching - out to get you and your wallet? Or is this reform that is long overdue? All I know is that it is a pain in the butt to deal with some borrowers whose loan used to be easy, and sad to have to tell some clients to go away.

So somebody moved the cheese, and nowwhat to do? Well, for mortgage LO's, it has meant having to get trained to do our jobs better (I recently took a two day class on how to read tax returns - something I had never bothered to do, because tough files could always go "stated"). And even though many write-off's can be "added back in" and counted as income - most still cannot.

Legitimate & legal? If they're on the return - probably. But I see some folks who get a little "aggressive" with their numbers too. So just be aware and be smart about what you do with your tax returns. It may not always be the wisest thing to do to claim every deduction possible - expecially when thinking about a new mortgage loan.

Glenn...

I think there should be a differentiation between cash expenses and long term expenses such a s depreciation. In the computer age it should be easy to accurately determine a borrower's "cash" income for the purpose of obtaining a loan.

There is a solution to this. See this website: http://www.fairtax.org/ It would eliminate the IRS and be fair to everyone.

We are returning to what existed pre-2000. It works against us the same way, when our CARs reduce our net income when we are attemting to qualify.

Hi Glenn: Thanks for the post. I tell all my borrowers that they need to write off less these days if they expect to qualify; especially on the purchase side. Most people don't have enough in the way of add-ons (depreciation, etc.) to show they can afford a place. Until we get better rules for self-employed borrowers we need to play the game. Of course I'm hoping that the IRS won't get involved. Government is too involved as we speak! Thanks again!

We just came out of a terrible period in lending history where borrowers 'fudged' their stated incomes. It was fraud. The discussions in this email are the exact discussions that existed right before we got ourselves into that debacle. "How can I cheat one hand and get the benefits in another."

When self-emoployeds gross $10k/mo, show expenses of $8k/mo and then easily afford a $3k/mo mortgage, then they have committed fraud. The write-off was either an actual expense or it wasn't. The inequities are balanced by those who do not commit fraud.

Most of us are self employed. I pay myself a salary each month from the company that I created. This may be the way to go. You save on taxes and know what you are making. Its a sub chapter S Corp. I am not currently forced to pay myself heathcare.

No one has addressed the fact that employed borrowers are evaluated on GROSS INCOME, and many of these borrowers also may have huge expenses that can be written off (real estate interest, taxes, medical expenses, etc.). If they are married and a spouse is self-employed, then they can write off all of the LEGITIMATE self-employed write-offs and still be evaluated on gross income.

On the other hand, self-employed individuals are always evaluated on NET INCOME.

I don't understand the people who say that you should limit your legitimate write-offs for any reason (I guess if your goal is to get a loan then as a strategy that might work, but wow!).

Hi Glenn, no doubt self-employed borrowers have a tougher time with financing unless they are showing tons of income...

They use their gross income but then they apply the %'s to basically get the net income we report with our write offs correct? The only complaint I have is the fact that I have been licensed for 15 years and when my wife and I decided to relocate to get more centralized with our family, they wouldn't use any of my income because I would be in a new area. I don't think they should have punished me 100% because of that.

I agree with all of the above comments. It's a catch twenty two for sure. What to do??/

Patricia Aulson/portsmouth nh homes

One of the perks of owning your own business is the ability to write off business expenses! My auto lease is a business write off, as is the gas I put in the car, and the insurance. That's why I am a small business owner and not a paid employee.

Glenn - There are definitely A LOT of benefits to being self-employed, but issues like this will come up.

by write off's you mean expenses right?

it is a valid question as to whether someone making less than $3000 per month can make a $3000 a month payment. didn't they change the guidelines because a large majority of people couldn't make these payments?

good blog. I like Tom Burris' comment about how you can't tell one branch of the govt that you make X and another that you make Y. There are indeed some legitimate write-offs that may serve to decrease the earnings on paper to a lower level than reality, but for the most part, it should be a pretty accurate assesment. Depreciation, for example, is allowed to be added back into the income because it's not a real "expense".

However, i do agree with one of the other comments which makes a very valid point - employees are allowed to count GROSS income, whereas self-employed income is derived from net income. They should both be calculated from net IMO.

It is becoming tougher on us independent contractors - last year, I couldn't get a car loan, because of the ratios - I could see their point, it does look like I spend more than I make. Actually, it feels like it, too. :)

self employed are gonna get killed in trying to get financing with all the credit tightening basically collateral damage due to all the stated income loans for those that really should of never gone stated income I am not sure why a bank would invent or allow a stated income loan for W2 person in the firstl place?

My husband I are in the process of purchasing a home and with my income being all sales and some of his coming in non taxable reimbursements (car & expense accounts) we had nearly $6K in monthly income that we could not use to qualify for a house! Talk about frustrating!!

It will be interesting to see if what you are saying comes true as those of us in sales can often write off parts of our homes and cars as viable and honest business expenses!

People that write off the world can still do loans. 40% down and a rate of 10% with 5 points. If they want to own a house and not pay as much in tax you can still get a loan. :)

Stated will come back just wait and see. Maybe not for w2 people. For now you need to get a hold of the tax returns asap and see if you have a deal or not and just let the agent know asap.

Sometimes you can get lucky on a tax return and maybe they show a big loss one year because they had to buy things for the business but that is not a every year expense so you can get 3 years worth of tax returns but you need to map this out for the underwriter so that they can see it.

SEP

You know when you are at closing on a loan there is this form 4506 that they hand you that gives the lender the right to request your tax returns. They usually give you the blank version of the form without filling in the tax year. I always have my clients list the years that they used when qualifying for the loan. Never give a mortgage company the right to look at all prior years or all future years. Who knows who could end up with that loan?

Heres another kick in the teeth that I recently discovered. Since I am "self-employed" I get to pay basically double the taxes of Medicare, SS (the employee side and employer side) I do not get credit for the SS taxes I pay! Its enough to make me wonder if I should pay the new bill I have on my desk to renew my NRA/MLS dues.

OOOPS Sorry....I meant NAR dues, NOT NRA dues! Need to find another cup of coffee here :)

I second the advise of Team Knowles - check out the Fair Tax at fairtax.org. When you realize what this could mean for self employed Realtors then think about how many others across this country who are in the same or similar situations and how they would be positively impacted! These are the very people who would carry this economy back into a period of economic growth on their "entrepenaurial backs" if we would let them! We need to stop digging taxation "potholes" for people who risk it all (like us) to fall into and start smoothing the way a little more!! Get informed and then make your voices heard at all levels -

Oops! Sorry about the lack of a spell check in my haste!! I meant to type "entrepreneurial"

GREAT POST, GLENN!!! I have been self employed for 32 years and have always had this problem at one time or another....It IS a connundrum. What do you do? Don't write off legit deductions to look better on paper...or write them off and look like you are living at the poverty level....???

Amen DEBORAH!! I have always thought it quite unfair that our NET is judged on the level of GROSS for otherwise-employed individuals. Fair Tax is starting to sound really good to me!

Susan Weeks - The AgentOwned Realty/Charleston, SC

Good story but this has been a problem for years. I have been a lender for more than 14 years and stated income loans are gone for a good reason. Now, regarding self employed people, not everyone should be a homeowner and that includes the self employed. If you are going to be an entrepreneur then you need to look at your business model because to make $3000 in revenue and then to deduct the same $3000 in expenses then you are not profiting.

Of course there are so many people in this position and I would like to see it change. Some of those expenses are optional and we should be able to write them off. I think bringing those optional expenses into the picture make for an unfair evaluation IMO. For example you could have purchased many items that you wanted to increase your business where you may not have chosen to purchase if you had the mortgage payment. I think it would be a bit more fair to analyze what did they write off. Perhaps analyzing the write-offs into 2 groups necessities and improvements. The qualifying income could be changed to (total income - necessities) = qualifying income. The idea may seem far fetched but I think it would be a better way to decide what to base loan amount on. I do not believe it is fair to make us go for 2 years without improvement to our business just to be able to qualify for a home. If we have the money to improve our business we should be able to do that without being penalized for doing so!

This is a problem for many that are self employed right now. It has always been an issue, but now qualifying is even harder. For those that are looking to downsize due to lower profits/incomes in this tough economy, it doesn't leave many options when looking to sell and qualify for another loan.

My wife and I are struggling with this now. We could by a home with payments cheaper than our rent, but our net income looks too low. I understand some of the write off's can be built back into the Income if they effect the home; such as the home office I deduct. I liked the old FHA standard of proven rent history instead of DTI to qualify. This may be a better test than DTI as it shows an actual ability to pay.

I am very agressive in my deductions but am actually considering paying more taxes in order to get my income up to try and buy a home!

This is a real dilema. I don't think it will go away. It is a little unfair that self employed are judged on net income, as opposed to gross income. great informative blog!

I'm not positive, but I believe that new regulation went into effect this month. Some of our mortgage brokers here can tell us.

The article I read said that borrowers must sign an agreement to allow the lender to access their tax records - first at application and then again just before the loan is funded. It further stated that the lender will be expected to get that IRS report and keep it in the transaction file for use in the event of a future audit.

So yes, the bank will see your tax returns.

I'd like to see statistics on how many self-employed individuals vs. wage earners have let their homes go into foreclosure.

Are we really a bigger risk than someone whose employer can just suddenly announce that they've been downsized or that their wages will be cut? I have a cousin who works for the State of California and her income has been slashed 3 times already - even though she's still doing the same work.

Self-employed people will keep looking for that next customer or client, and our incomes don't depend upon just one "boss," so we should be a smaller risk than a person who would need to start over with searching for a job in this "lay off" market.

Anyone have those statistics?

marte at http://www.copybymarte.com

Yes, the gross icome vs the net income. Not even remotely fair. Also, the fact that self employed folks have to average out 2+ years of income makes it harder to buy when you are first starting out.

It is the same type of problems when qualifing for a condo as opposed to a single family home. Why do they count the HOD, but not the sames expenses for a single family?

Interesting why so many people would feel their privacy is invaded and offended that the govt. would investigate fraud.......no one likes being caught I guess. I wonder if people feel they have the right to commit fraud in the privacy of their own home?

When employed people write off business expenses, those too are deducted from income. A 4506 IRS verification is done on all borrowers. The playing field is fair. Lenders must look at income available to repay the debt. Real income - verifiable income - claimed income.

It is apparent to me that the Jana (#51) has never been self-employed if she thinks the playing field is fair.

susan m weeks

the agentowned realty company/charleston, sc

Seems to me we are confusing Gross Revenues with Gross Income. Tom (14) and Joe (23) offer good insight. Expenses that aren't 'real' expenses - such as delpletion, depreciation, home office use, and auto loans, are always added back in as 'income' - resulting in a fair playing field.

Jana

P.S. I've been both and paid much less less income tax while self-employed...

It looks like the government is basically saying to the self employed, "you want a loan, don't write off so much". Isn't this a form af tyranny? Write-off rules were put in place to encourage people to start their own business - to encourage entrepreneur-ship. Small business is the building block of this country. So an alternative method for determining ability to pay back should be used for self employed people, who use the tax code to legally reduce their taxes.

People can get laid off the day after closing, or they could quit and start their own business. If you have two different people in the same exact business, who each made the same exact money, one would pay a lower tax than the other due to their, or their accountant's, interpretation of the tax code. So elimination of the IRS would be a great first step to make the tax code fair, and easy for all. But we need to get by the "Turbo Tax" and "H&R Block" lobbies. Thank you Team Knowles for the heads up on the fair tax site - http://www.fairtax.org/

Bottom line: You can't count it as income if you are deducting it as an expense. Income is what you have left. If it requires buying a company car, & advertising, & gas, insurance, tolls, meals, & other entertainment, computers & software in order to generate the gross income, then these are legitimate expenses & deductions. What is left is considered income, & what you pay taxes on.

As a W2 employee, you generally do not have to foot the bill for generating the flow of business & revenue. This is why W2 get to use their gross income, as they generally do not have nearly as many business expenses.

The reason the same rules don't apply as far as S/E vs W2 is that it is inherently easier for a W2 employee to go get another "job" vs how difficult it is for a failed business owner to start another company.

We see too many Pizza shop owners & Building contractors living the lifestyles of the rich & famous while paying very little in taxes. I have seen substantial six figure incomes reduced to $20-30,000 a year on tax returns.

I do agree that the current system is ridiculously flawed.

SEP

This is the best benefit AND the biggest setback to being self employed: claim everything, however, now you don't qualify to buy. It is a Catch 22.

This is a situation noticed by my clients (mostly mortgage brokers) 2 or so years ago.

It has absolutely nothing to do with labor unions - the meltdown hysteria put the Alt-A loans in the same budket as subprime. Lenders closed the gate on mortgages that used bank statements + credit score to qualify borrowers. That essentially killed the market for self-employed borrowers.

I am really surprised that it hasn't generated more protest from the self-employed - but oh well.

YoUGGs.Org - online ugg blogging magazine,daily updating free webblog information including bargains on ugg boots sale,released fashion australia ugg cardy,seo and so on,welcome friends wordwidely enjoying and pouring new trends,google insight guide you how to farword youtube developing. http://www.youggs.org

More scary stuff from the effects of the current administration. As a general contractor for more than 25 years, I've always worked off a 'stated income' (liar's loans?). That has become increasingly difficult now, whether your situation has changed or not. Mine has, in that construction activity across the country is down now more than 50% and I am in a resort area, in a county that has one of the highest unemplyment rates and highest foreclosure rates in the country. In addition, because it's a resort area, we are one of the first to get hit by economic downturns and one of the last to recover. We've been trying for a loan modification on our personal residence but it's been no dice as dipping into your savings and selling off assets, as most contractors do as a tactic when things are slow, is not income. On top of that, as appraisers, we have been hit hard by the HVCC. Tough spot right now.

"More scary stuff from the effects of the current administration. "

Actually, this problem predates the current administration by quite a bit. My husband and I are both self-employed, and as soon as the housing boom began to go south and mortgage lenders started tightening up on loans, the stated-income loan was basically a thing of the past. And that was late in the Bush administration...nothing to do with Obama.

Our current loan is due to adjust in January of 2011, and I have no idea what is going to happen. I would LOVE to lock in a rate now, but there's no way we would qualify using our present income[s]. Basically, we're just waiting to see how things shake out closer to that date. Very scary.

Sonsie, you bring up a very important point. Many people in our industry are facing future adjustments of their mortgage interest rates, think they could refinance in the future. But without bottom-line income showing on their tax returns, they can't qualify. And current lending rules say your income must show on your returns for two years in order to count.

Does that mean the self employed need to go back and modify 2008's tax returns and eliminate legitimate tax deductions - paying higher taxes that they aren't legally obligated to pay - in order to boost income enough to qualify for a refinance loan once they file 2009 returns?

I wonder how lenders would view a modified 2008 return + a 2009 return? Right now, we have to execute the 4506T on all self-employed borrowers, and I'm sure this modification would show up. So do you take a chance - pay taxes you don't owe, along with penalties, in order to get an interest rate you can afford? Or do you wait to see what happens? Ouch!!!

SEP

This has been a problem for decades. It began when lenders started using the number system for qualifing for a loan instead of "character" based lending. Character based lending is considered racist now even though it makes far more sense than basing mortgage qualification strickly upon income. If I buy a 100K property for $20K, refinance it for $70K, spend another $20K repairing it, then pocket $30K, keep it and rent it out, technically I've made $30K. However, I'm not required to show that as income according to current IRS rules until I sell the property. Then it's taxed as a capital gain, not income. So by all rights (their rules) I can show zero income on my tax return for that project for that year (except for rent I collect after expenses), and every year until or if I decide to sell the property. So if after one year I've collected say an additional $1200.00 in rent after expenses my tax return will show income of $1200.00 not $31,200.00 which is what I actually made. That income tax return will generate lots of laughter from a lender if you try to now obtain another loan for a new project even though that kind of investment/business plan is very profitable, completely legal, and perfectly viable. The moral of the story IMHO is that banks seem to employ some of the stupidest people and policies on the planet. My experience is that half the time you can't LEAD them by the nose to the money trough. I shouldn't be required to pay taxes I'm not required to pay until they're due just so I can show a profit on an income tax return that I can show to a lender so I can legitimately borrow money for my highly profitable real estate projects. In the savings and loan fiasco last decade I had my credit cut off after years of lenders making absurd returns on my projects because they claimed they didn't want to be in "My kind of business anymore." This time around I've been more careful yet here we go again with lenders cutting me off, going out of business, etc. Since I've never created any of these problems, never had an investor or a lender lose a penny on any of my projects over the last 25 years, I want to know where my BAILOUT money is from the government because lenders are ONCE AGAIN trying to put me out of business for no good reason. Got to get back to work. End of rant.

SEP

Wow Glen, you are really shaking the trees. 62 now 63 comments and the coveted star. Congrats!

My 2 cents.

Perhaps those who borrow so much that their mortgage payment is greater than their declared income really should not be borrowing as much anyway. If you claim expenses to reduce your taxable income that is money that after all has been spent on something else and is therefore not available to pay the mortgage.

Cheers.

OCT

How would a lender view amended tax returns that have eliminated expenses? Is it legal to amend tax returns & eliminate expenses?

I had a borrower who was considering this, but remember: Tax returns are reviewed over 2 years, and each line item needs to match up reasonably with the year before/after. If you reduced your write offs on the last years returns, and they didn't match up with the year before that, it wouldn't work. So you're maybe talking about amending 2 years of returns. And when you do this, you increase your tax liability. And then your underpayment of taxes will be penalized by the IRS. And now you're looking at some real expenses. Plus if it didn't work, you'd still be paying those IRS penalties.

It didn't look like a good plan to me.

I'm talking about amending 3 years of tax returns. Some people (such as farmers) have "loss carry forwards" that would take up the slack and still not have to pay taxes. How would the IRS view 3 years of amended returns to eliminate expenses? The income would look much better as far as re-financing is concerned. It's very difficult to find any information on Google about eliminating expenses on a tax return (it's all about claiming expenses).

I'm not a CPA - so don't take this as legal advice. For mortgage purposes, line items are analyzed over two years. Anything that is not consistent from year to year usually gets tossed out. So a large one time expense would get tossed, but also a large increase in earnings might get tossed too. The simple answer is anything that normally happens from year to year gets considered. So trying to suddenly reduce your expenses to boost your income may not work, based on what happened the year before. Yes, it is legal, as far as I know, to pay the government more taxes by removing deductions through an amended return.

I've not had to run one of these past an underwriter for consideration, so no idea what would happen. My guess is that you could make it work some places and others would frown on it. But again, keep the "normal" rule in mind. Also remember, the lender is going to ask for official transcripts from the IRS on every such deal, and your amended returns will be provided along with the previously submitted return - so there won't be any mystery about what transpired.

Leave a response…

Name:

Email:
(optional)

Comment:

What does the graphic say?