Young, Self-employed, and Trying to Buy a Home: Part Three (Taxes)
Disclaimer: We're not professionals and this is not financial advice. This is just a summation of things we've learned while being self-employed and trying to buy a home.
This is our third post in our home buying series, a little collection of posts focusing on the steps to home ownership for folks who, like us, are self-employed. We've covered the reasons as to why we're tryna buy a home, and also a bit about saving for a down payment. And now for part three, we're discussing some of the things we've learned about taxes and their role in your home buying process. We'll get into it all below, but basically: this post is about why you'd be screwing yourself over in terms of qualifying for a bank loan if you try to under report your earnings in an attempt to pay less to the government.
First, before we end up getting audited just because of the title of this post, yes we pay our share of taxes and yes it sucks and yes it would maybe not suck so much if paying taxes resulted in single payer affordable healthcare and education and if our street weren't more uneven than the surface of the moon. But hey that's life or whatever.
Alright - so we're gonna break it down to the bare basics for a second for those of you who, like us a couple years ago, don't have much experience with doing taxes for self-employment. There are a ton of different tax forms, but most people who have traditional employment get a W-2 from each job they work over a calendar year. That basically means that before you receive each paycheck, all of your taxes have been taken out and sent off to the government already. During tax season, this means you just punch in info from your W-2, and if you're lucky enough, Beyonce herself may grant a portion of it back to you in the form of a refund. And then you're basically done. Party.
For self-employed folks, there's a variety of tax forms you may need to use depending on what the work is, but the most common is a W-9, used for freelance and contracted work. For every person who is paying you over $600 for your labor, you fill out a W-9 with your personal information or your LLC's information. When you receive payment, none of the taxes are taken out - so if the job was for $1,500, your check says $1,500. It's on you to take the action of putting aside a percentage of that money for your taxes. Yes it's tempting not to take anything out and yes that's a horrible idea. You'll then be sending off that money to the government quarterly, or, if you really want to hate your life come April, you can do it all at once when you file your annual income taxes.
When you go to file your taxes, you'll be able to "write off" certain expenses as being business expenses. Basically, anything that is going directly towards furthering your business (everything from the costs of your website to a portion of your rent if you have a home office) shouldn't be counted as your personal income and won't be taxed as part of your income tax. So let's say you're a self-employed writer who brings in $60,000 in 2017 but you've got to pay for an office space, travel to and from jobs, a new computer for work, etc. and it all comes out to $15k spent in expenses for your job. If you report that $15k as business expenses and not actual income, you'll be expected to pay income taxes on only $45k instead of the full $60k.
This is the part that gets tricky. A common belief of the self-employed is that the more you can write off the better - and to be honest, because the industry varies and encompasses such a wide variety of labor, you can often write off a ton of stuff without turning heads. For example, maybe that fancy lunch that was with a close friend but you discussed a business project you'd like to work on together - or that trip to a swanky resort was for "research." Sometimes folks will go ahead and write those off as being business expenses because it was furthering their business. That kind of expense reporting is kind of up to your discretion and we're not going to tell you how to live your life.
The problem, though, comes in when you're looking at trying to get a loan for say, a home (a là the point of this entire series). Banks want to see that you've got decent income compared to your debt, and yeah guess what - they're first going to be looking at your tax returns for this information, and if you said that you made basically nothing, well, that doesn't look great for your odds of being given a home loan. This is why, on the flip side of under-reporting your income, some folks who are trying to qualify for a bank loan and who've got the money to shell out for higher taxes will actually under-report their expenses to inflate their income (and, yes, pay the income taxes on that money). We've done some hunting around and discussion with a CPA and it appears this is 100% legal and common, and results in you looking like a more desirable loan applicant.
Need to break for a cocktail? We don't blame you. Here, have one of these Peach & Serrano Margaritas. Yay alcohol.
All of that said, some mortgage lenders will sometimes take business expenses into account when analyzing your annual income, which just means a portion of your expenses could be added back to your total income for the purposes of seeing a more realistic depiction of how much money you actually have access to. For example, if you're writing off a portion of your rent as a home office expense, a mortgage company can reasonably assume this expense will no longer be a concern once you're a homeowner (because you obvi won't be paying rent on a separate apartment, now you'll just be paying your mortgage), so that amount may be added back to what your income is projected to be once you're in mortgage repayment. This varies from lender to lender, so we won't go much more into it, but anyone from a mortgage company should be able to walk you through it easily.
So it's a balance. The most headache-free way to go, which should really go without saying, is to just report as accurately as possible what your expenses and income were. This way there's no chance of trouble down the road, and you won't end up qualifying for a bank loan that you can't actually afford to pay back. One of the most fundamental ways to keep track of business expenses when working freelance, if you haven't already, is to open a separate business checking account with a debit card that is only used for your business expenses. This is basically free of charge to do and will keep a super accessible paper trail of where all the money that goes into your business is going - whether it's paid to your personal account as an owner distribution or spent growing your business.
What we did, however, caused a little bit more of a headache than that, because we own equal shares of a two-member LLC. That means it's just a couple more steps to determine exactly how much each of us personally made from the business. First, we took into account that the homes we're looking at buying are all under $200K, even after construction loans. That's not terribly expensive in the grand scheme of things, and we didn't feel that "inflating" our income by underreporting our expenses would be as helpful to us as being able to put more money into savings, thinking about building up a chunk for a down payment. So, we took our own advice and reported everything very very accurately and had a little chunk of money left from our tax savings to put into our home savings account.
Two tools we've found to be remarkably helpful in this process (besides having an amazing CPA): Intuit Quickbooks and Intuit TurboTax. We use Quickbooks to process and send all of our invoices, and it helps organize our bank statements and track funds. TurboTax was super helpful for filing our personal taxes, and though you'll have to pay for the Premium version to do self-employed taxes (as opposed to standard taxes), it's about $120 and insanely convenient.
Hope this has helped a bit, and as always please comment below or shoot us an email if you've got any questions! See ya next time!!