How hard is it for self-employed people to get a real estate loan? While this is a topic we’ve touched on before, we haven’t yet done a deep dive on the subject.
To get the full scope of what it takes to get a loan and dispel some common myths, I sat down with Bill the Lender, Bill Rodriguez of Cornerstone Lending. Listen to the podcast or watch the video to get the full discussion.
- Listen to the podcast “#72: Can I Qualify for a Real Estate Loan If I’m Self-Employed?” on the Colorado Springs Real Estate Investing Podcast
- Watch the YouTube video (at the bottom.)
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
From a Lending Perspective, What’s the Difference between a W-2 Employee and a 1099 Contractor?
Lenders view a W-2 employee as a single person; the main concern is their creditworthiness. Conversely, since a 1099 contractor is a business owner, lenders take the entire health of the business into account. The business owner assumes all of the risk of the business, whereas a W-2 employee is just evaluated on the steadiness of their income.
When it comes to business owners, they itemize everything that comes through the business. All of the benefits and costs get subtracted from the revenue. So, what’s left at the end of the day after all of that is what lenders have to work with.
Essentially, the difference comes down to only looking at creditworthiness of the W-2 employee and evaluating the health and cashflow of the 1099 contractor’s business.
Is It More Difficult to Get a Loan If You’re Self-Employed?
Bill says that just because you’re self-employed, that doesn’t necessarily mean it will be hard for you to get a loan. There are some additional underwriting requirements and more documentations to navigate. However, as long as you’re proactive, you can avoid the pitfalls. It’s important to have a real estate agent who understands their client’s unique financial situation. It’s also vital to talk to a lender early in the process.
Often, lenders and financial planners are diametrically opposed when it comes to how much they view income. Tax professionals will advise self-employed business owners to write off any allowable expenses to minimize income taxes. From an underwriting perspective, though, Bill wants to show as much income as possible for them to qualify.
Any borrower who wants to buy a home or jump into the real estate game should have these conversations early. This allows Bill to work with the borrower’s financial team to make a plan. He’s not a tax expert, nor can he give tax advice, but he can help navigate the process from a lending perspective. Together, Bill and the financial team can figure out the right balance of paying taxes and writing off expenses to meet their client’s goals.
How Do You Find the Balance between Writing off Expenses and Showing Income?
This balance is always in flux, especially as there are changes to what clients can and can’t write off. They key is to look at the overall expenses for the business and reduce the amount of them.
Even after a client files a return, it’s possible to work with a CPA to make changes retroactively. Sometimes this entails filing an amendment to the prior year’s return. Any changes made after filing comes with penalties and interest, so it’s usually better to figure it out in advance.
Typically, a self-employed person has a long-term plan. That plan allows them to decide what’s going to be more important for the year before they file taxes. This can mean graduating their income over time so they aren’t paying taxes all at once.
Do You Need to Have 24 Months of Income before You Can Qualify for a Loan?
Bill says that it’s a common myth that 24 months of income is the required timeframe for self-employed borrowers. There’s no hard and fast rule for the business’s age, but he likes to see 10-12 months on a tax return. The tax return can be supplemented with current year-to date-balance sheets and Profit and Loss (P&L) statements. This paperwork shows that the business is growing and is cash positive.
Cornerstone has an entire team dedicated to helping people with more complex finances qualify for a loan. This team collects all of the necessary documentation to provide a deeper analysis of the borrower’s true financial situation. Borrowers who have great credit, reserves, and other compensating factors are good candidates for loans.
What Are Some Common Hiccups That Occur in the Process?
Losses are the biggest issue that comes up. If a business is under five years old, income will be estimated at the most conservative level. The current rule is that if income is declining more than 4%, it’s a red flag for underwriters. If the income is declining year over year, the year with the least amount of income will be considered. On the other hand, if the business’s income is increasing, the last two years’ income will be averaged. For example, if the borrower makes $60K the first year and $100K the next year, their income will be $80K for lending purposes.
This is why it’s so important to have conversations with the lender early in the process. Often, borrowers assume they will be evaluated differently than they actually are and are disappointed with the result. Bill’s goal is to help borrowers get what they want with ease and avoid unnecessary disappointment.
Are There Certain Industries that Are Riskier from a Lending Perspective?
The only industry that Bill can’t work with because of federal mandates is the pot industry. They can only lend to W-2 employees within these businesses but can’t work with the owners.
Otherwise, the businesses are evaluated purely on their bottom line. Even if a business has with a lot of inventory or expenses, it’s still possible for the borrower to qualify for a loan. The borrower will need to show receipts and explain the expenses.
For example, if there were a capital investment in equipment, or the business was in acquisition mode, then the underwriters can take those expenses into account. A one-time expense has to be properly labeled so that underwriters can determine that it won’t be a recurring cost.
Is There a Benefit to Having W-2 Experience in an Industry in Which You Become a 1099?
From a job stability standpoint, Bill says it looks good show that the borrower already has experience in a certain field. However, they still need a minimum of 12 months doing business as a 1099.
Since the borrower’s previous employer is no longer paying for the cost of the business, the borrower needs to show they are capable of running their own business. The tax return is generally regarded as a P&L statement that shows the health of the business.
When a person starts a business in an entirely new field, they need to substantiate their expertise in the new industry plus show that they can run a healthy business. There are arguments to be made that the borrower developed necessary skills in their old position, but they still need to prove that they can manage a business.
Can a Real Estate Investor Show They Have Relevant Experience from Managing Their Portfolio?
Many of our clients start investing while they have a W-2 job with the intent of retiring and focusing solely on real estate. They’re often worried that once they quit their W-2 job, it will be harder, if not impossible, to qualify for a loan.
Bill says that managing a portfolio can prove expertise as long as they’ve self-managed a property. Even if they only self-manage one out of their ten properties, it shows that they have the necessary business acumen. Underwriters won’t look at the ratio of their properties, just a demonstration of expertise.
Connect with Bill
While self-employed business owners have to think more strategically and produce extra documentation, getting a real estate loan isn’t as scary or impossible as is commonly thought. Getting the lender involved well before deciding to buy a property is the best move they can make. Once you know you want to buy a property, having a few conversations ahead of time can save you a lot of heartache and pain.
If you want to learn more about this process and form a lending strategy, reach out to Bill:
- Website: www.rodriguezhouseloans.com
- Phone: 303-877-6323 or direct line: 303-926-0070
- Email: Brodriguez@houseloan.com
Connect with Us
This conversation is a good reminder of why we always tell our clients to get financing in place before finding a deal. If you want help navigating this process so you can achieve your investing goals, reach out to us. We’re always happy to help connect you with lenders and other vendors who will help you close on the right property for your strategy.