posted on April 19, 2014 07:00
When applying for a mortgage, lenders will classify you as a wage earner employee or self-employed. Furthermore, if you also own a business or a percentage of a business, you might be considered self-employed even though you are a W-2 wage earner. If this is you, here’s what you’ll need to know to complete a mortgage application.
To start with, here are the income classifications for lending:
- Employee: Individual is a W-2 wage earner and receives a paycheck. Taxes are withheld from the paycheck.
- Self-employed: This includes everything else – a sole proprietorship, any business entity where income is derived or lost (including all affiliated corporations), and income derived from real estate or dividend income.
Where the Two Worlds Intersect
Bona fide employees who also have an ownership interest in the company can actually be considered self-employed. For example, if you’re a W-2 wage earner employee and you also have more than a 25 percent ownership interest in the company that employs you, this would earmark you as’self-employed for the purposes of completing a mortgage application. If you happen to be a W-2 wage earner, but you have a percentage of ownership in another business, you would be considered both an employee and self-employed.
Business Ownership and Getting a Home Loan
Your federal income tax returns are required for the purposes of documenting your ability to repay when securing a new mortgage. On your tax returns, as a sole proprietor you file a Schedule C, and this income carries over to Schedule A. Most sole proprietors don’t have separate business entities, so corporate returns are not required as it is 100 percent ownership. However, things are different when you have an ownership interest in a company.
- Schedule E identifies whether there is additional business income and/or that you are an owner in an additional business.
- If an additional business is present on the return, the mortgage lender will require a K-1 to determine the percentage of ownership.
Mortgage Tip: If you own 24 percent of a business, you are not considered self-employed for the purposes of the loan application, and the lender will not need to obtain the corporate income tax returns. However, if you own 25 percent or more of a business – whether it’s your current employer or another business entity, as identified on the K-1 – then, yes, you’ll need to provide additional income tax returns for the entity in addition to your personal tax returns for obtaining the mortgage.
Why All Income Examination Matters
An ability-to-repay analysis is required on all mortgage loans. Simply providing W-2s, pay stubs and personal tax returns is not enough if you have more than a 25 percent business ownership interest in another company. If you’re receiving additional income from another business, and that income is tied to your personal tax returns necessary for securing that mortgage, it becomes necessary for the lender to have the additional tax returns because they support your reported income and subsequent ability to repay. Lenders are required to average your income in most cases during the past 24 months (including the business income) and that averaged income or loss will be used on the application in accordance with obtaining the new mortgage.
A financial word to the wise for the self-employed: You don’t need to provide the additional tax returns if you are a small minority share owner in a company.
This article was written by Scott Sheldon and originally published on Credit.com.