How Tax Write-Offs Affect Your Mortgage Qualifying Income

Tax write-offs lower your mortgage qualifying income because most lenders start from the net income on your tax return, after deductions, rather than from your gross revenue. Some deductions that do not use cash, such as depreciation, may be added back when a lender analyzes self-employment income, but most ordinary business expenses stay deducted. If your returns show much less than your business actually produces, alternative-documentation non-QM loans that read bank statements or a P&L may be an option. For decisions about your own taxes, talk to a tax professional.

Why lenders start with your tax return

Under the CFPB's ability-to-repay rule, lenders must make a reasonable, good-faith determination that you can repay, and they generally verify income using third-party records. Copies of tax returns filed with the IRS are one of the main records the rule points to. For self-employed borrowers on the standard route, those returns are the foundation of the income calculation.

If you are a sole proprietor, your business income and expenses appear on Schedule C. The figure that matters most to a lender is the net profit at the bottom, not the gross receipts listed above it. Partnership and S corporation owners see the same effect through the income that flows to their personal returns.

How a deduction becomes a smaller loan

Every legitimate business deduction reduces net profit. Lower net profit means lower qualifying income. Lower qualifying income can mean a smaller loan amount or a debt-to-income picture that does not work for the loan you want.

Think about common write-offs:

• Vehicle expenses for a truck or car used in the business.
• Equipment, tools and computers.
• A home office.
• Travel and meals tied to the business.
• Contract labor and subcontractors.
• Supplies, software and subscriptions.

Each of these lowers your tax bill. Each one also lowers the income a lender counts on the standard route. That is the trade-off many self-employed borrowers do not notice until they apply for a mortgage.

What lenders may add back

Not every deduction represents money that left your business that period. Lenders analyzing self-employment income often adjust the net figure for items that reduced taxable income without reducing cash flow. Fannie Mae's Selling Guide, for example, requires lenders to prepare a written cash flow analysis of self-employment income, and its tools are built to make these kinds of adjustments.

Items lenders commonly consider in general terms include:

• Depreciation the IRS describes depreciation as a deduction that lets you recover the cost of certain property, such as vehicles, machinery and equipment, over its useful life. Because the purchase may have happened earlier, the periodic deduction does not represent a fresh cash outlay, so lenders often add it back.
• Depletion and amortization similar non-cash deductions that can be added back in some analyses.
• Certain one-time losses or expenses items that are clearly non-recurring may be treated differently, with documentation.
• Business use of your home some analyses treat part of a home office deduction differently, depending on the guidance the lender follows.

What lenders generally do not add back are ordinary operating expenses that represent real cash leaving the business, like supplies, labor and rent. Add-back rules depend on the lender and the guidance it follows, so ask how your returns will be analyzed.

Non-recurring income can work the other way

The analysis is not only about adding income back. Lenders also look for one-time income that inflated a period, such as a sale of equipment or an insurance payout, and may subtract it because it is not likely to continue. Fannie Mae's guidance emphasizes income that is stable and reasonably expected to continue. A lender is trying to estimate what your business will keep producing, not just what it produced once. If your income jumped because of a single large contract, expect questions about whether similar work is lined up, and have contracts or client letters ready if you can.

When write-offs push you toward a non-QM loan

If your add-backs still leave your qualifying income too low, you are not necessarily out of options. Non-QM programs use different records:

• Bank statement programs these commonly review 12 or 24 months of personal or business statements. An expense factor is applied to business deposits, or a CPA- or tax-preparer-prepared expense letter is used.
• P&L programs these use a profit-and-loss statement prepared or verified by a CPA, EA or licensed tax preparer.
• 1099 programs these look at the 1099 forms you receive with an expense factor applied.
• Asset depletion programs these divide eligible assets by a number of months the program sets to create a qualifying income figure.

These loans are still subject to the ability-to-repay rule. They often price higher than agency loans because they carry more risk for the investor, and lenders may expect a larger down payment or more reserves. Programs vary by borrower, property and investor.

Should you take fewer write-offs to qualify?

Some self-employed borrowers consider claiming fewer deductions or filing amended returns to show more income before applying for a mortgage. That decision has tax consequences, and lenders may look closely at returns that change shortly before an application. It is not a decision to make based on a mortgage alone.

The better approach is usually to plan ahead. If you expect to buy a home in the next few filing periods, bring that goal into your conversations about taxes, and compare what a higher tax bill costs you with what a non-QM loan would cost. For any change in how you file or what you deduct, talk to a tax professional.

Reading your own return like a lender

You can get a rough sense of your qualifying income before you apply:

• Find the net profit on Schedule C or the income flowing to you from a partnership or S corporation.
• Note any depreciation, depletion or amortization claimed.
• Look for one-time items, such as asset sales, that may be removed.
• Compare the result with your bank deposits over the same period.

If the gap between your adjusted net income and your deposits is large, ask a loan officer to run both a full-documentation scenario and an alternative-documentation scenario. Pull your IRS transcripts too, so you know exactly what the lender will see when it confirms your returns.

Working with your CPA and your lender

Your CPA or tax preparer can help explain your returns to a lender, prepare an expense letter for a bank statement program, or prepare a P&L for a P&L program. Your loan officer can show you how each route affects your numbers. Every loan is subject to credit approval. For questions about your own deductions or filings, talk to a tax professional.

Frequently asked questions

Next steps

• Self-Employed Mortgages
• Bank Statement Loans
• Self-Employed Mortgages in Florida
• Self-Employed Mortgages in New York
• Self-Employed Mortgages in New Jersey
• Self-Employed Mortgages in Pennsylvania
• Self-Employed Mortgages in Connecticut
• Self-Employed Mortgages in Virginia

Sources

• IRS: About Schedule C (Form 1040), Profit or Loss from Business
• IRS: A Brief Overview of Depreciation
• Fannie Mae Selling Guide: Underwriting Factors and Documentation for a Self-Employed Borrower
• Fannie Mae Selling Guide: General Income Information
• CFPB: What is the ability-to-repay rule?
• IRS: Guide to business expense resources