Buying a home requires saving, planning and a lot of preparation. You’ve heard the importance of good credit, so you’ve worked hard to clean it up to increase your credit score. You’ve also learned a lot about pinching pennies to increase your savings from skipping the excessive eating out to switching to bagged lunches for work. It paid off as you now have a decent credit score and a good savings accumulated in your bank account. You’re now ready to start your home search. But wait, your newly hired Realtor told you it’s important to get yourself Pre approved for a home mortgage. You visit your Mortgage Broker to begin the process.
Today’s guest author, David Sheir, a Florida licensed Mortgage Banker and Certified Public Accountant shares his experience on the one thing your Accountant won’t tell you.
There is an old saying that the only things in life that are certain are death and taxes. And, just like the popularity of anti aging products, many of us rely on the expertise of our accountants to prolong or minimize our payment of taxes. Accountants ask us to send them the details of all the expenses we incurred in any given tax year to determine which costs can be deducted to lower our taxable income thus lowering our taxes. We often measure the quality of our accountants’ services based on how much they are able to save us on taxes. The lower the tax bill, the better the accountant and the happier we are.
Here’s the one thing your accountant won’t tell you as you jump for joy over the refund you expect to receive. Lower taxes most often means a lower mortgage loan when it comes to applying for a pre approval. “How can that be when I made $ xxx this past year…” is a question I am often asked. Well, you see, you may have “grossed” $ xxx last year but you then wrote off $ yyy against that income meaning that your “net earnings” were $ zzz. And net earnings is the figure we in the mortgage business use to qualify you for a mortgage.
Personal taxes and home buying
So, here is how it works. An individual who works for a company as a W2 employee reports his or her compensation from the employer as W2 income on page 1 of the tax return. Then they report “unreimbursed business expenses” on a schedule A for expenses they claim were necessary in generating their employment income. These expenses are subtracted from the W2 earnings in calculating taxes thus lowering their tax bill. However, this net figure is also the same number that a mortgage lender will use when calculating the debt to income ratio when that person applies for a mortgage. The debt to income ratio is one of the key yardsticks used in my industry in determining a person’s ability to repay a mortgage loan.
Perhaps an example of a real scenario that recently passed my desk will help shed some light. I recently had a woman apply for a mortgage who has worked for VISA as a customer service representative. Her job consists of sitting at a desk answering customer calls. She is great at what she does and an exemplary employee. She earned $50,000 in W2 income in 2013. This would generally qualify her for a $150,000 mortgage assuming all other credit and debt factors are in line. Upon my review of her 2013 taxes, however, she reported $20,000 in unreimbursed business expenses on schedule A bringing her net earnings down to $30,0000. While she was happy about her 2013 tax refund, she wasn’t exactly thrilled when I mentioned that her maximum mortgage approval went from $150,000 down to $100,000. Her response…”my accountant didn’t mention that to me.”
For self employed consumers and independent contractors, this topic is trickier. You see, a self employed consumer can report their business income a variety of ways depending on their legal and tax structure. They could be a sole proprietor (schedule C), an S Corporation, or a C Corporation. An independent contractor is usually a sole proprietor. Regardless of structure or tax reporting, the issue is the same. The higher the business expenses reported, the lower the mortgage amount. There are a few exceptions where certain non cash business expenses are not counted against mortgage qualifying income such as depreciation.
While I believe a person should never pay more than the minimum tax their legally obligated to pay, I want to caution consumers who are planning to purchase a home in the next two years (two years worth of tax returns are always requested by a mortgage lender). Be sure to balance properly your goals of paying the least amount of income taxes you’re legally obligated to pay with your goal of qualifying for the right mortgage amount you feel is necessary for the home that is right for your family. When meeting with your accountant, let them know you will be applying for a mortgage. Otherwise, they just might not bring it up.