Many self-employed individuals report expenses on their taxes to reduce their tax liability, but this can backfire when they apply for a mortgage.

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If you are self-employed, you already know the benefits that come with making your own decisions and never having to report to a boss. However, there are some disadvantages to generating your own income when it comes to applying for a home loan.

“There are two main problems that self-employed borrowers face when qualifying for a mortgage,”says Cory Martilla, corporate-sales manager of Supreme Lending in Dallas.

“First, they need to prove their income with tax returns rather than using a ‘stated income’ loan. Second, the recession has caused declining income for many self-employed people. Even if their income has stabilized, the loan will be based on the average of two years of tax returns, which could show reduced income.”

Gregg Busch, vice president of First Savings Mortgage Corp. in McLean, Va., says that stated income loans were originally designed for self-employed people but were abused by too many people buying homes they could not afford.

“Stated-income loans are starting to make a small comeback on the secondary market, but only for borrowers with good credit scores of 720 or above, a down payment of 30 percent or more and at least six months of cash reserves to cover all monthly obligations, not just the mortgage,” Busch says.

Andrew McDonough, branch manager of the Seattle office of MetLife Home Loans, says that stated-income loans may eventually be available again from private lenders, but borrowers are likely to pay a higher rate.

“In the mid-1990s we used bank statements to show cash flow for self-employed people, but that is not an option today,” McDonough says.

Self-employed borrowers must complete Internal Revenue Service Form 4506-T, which allows lenders to request tax transcripts. Lenders are required to wait until the tax returns have been recorded by the IRS and must receive them directly from the IRS rather than from loan applicants.

Many self-employed individuals report expenses on their taxes to reduce their tax liability, but this can backfire when they apply for a mortgage.

“Self-employed people typically report their gross income minus expenses to generate a net income,” says McDonough. “For tax purposes, it may be beneficial to have net income as low as possible, but the net income is the number used for income qualification.”

Martilla points out that borrowers who claim $100,000 in income and $100,000 in expenses will find it nearly impossible to qualify for a loan unless they can prove they experienced a one-time loss or have purchased something that will enhance their business in the long term.

McDonough says that even borrowers with $2 million in the bank and a credit score of 800 may not be approved for a mortgage if they do not have a qualifiable income stream.

McDonough says that one of the biggest issues is declining or unstable income, which can prevent borrowers from qualifying for a loan.

Borrowers who made $100,000 in one year and $50,000 the next will have a qualifying income of $75,000, even if they are making closer to $100,000 this year.

Martilla says that if a borrower’s income declined by less than 20 percent, some lenders will qualify them based on the previous year’s income and a year-to-date profit and loss statement from an accountant.

In addition to proving income, borrowers must prove their business exists. For some lenders, two years of tax returns are sufficient.

Other options for verification include a statement from an accountant, a business license, a website and client statements or copies of 1099 income statements.

Martilla says that while most self-employed individuals must have been self-employed for two years to qualify for a mortgage, sometimes an exception can be made for someone who can show one year of self-employment on his or her taxes as well as W2s from a previous employer in the same field.

Self-employed borrowers who apply with a co-applicant still need to follow the same process of proving income. Those who report a loss on their taxes may be better off applying only with the co-applicant’s income. For example, if one borrower earns $100,000 and the other has declared a loss of $10,000, their combined income is $90,000.

Martilla says making a larger down payment can help if the borrowers are close to qualifying and the smaller loan size lowers their debt-to-income ratio enough.

“Self-employed borrowers need to understand that the most they can borrow is simply based on their qualifiable income,” McDonough says.