If you're planning on getting a mortgage, you may want to rethink taking any extra deductions to minimize your tax liability this year. Writing off expenses you incur as a W-2 employee can have lasting negative repercussions on your real income, an anchor component of how lenders determine your creditworthiness.
You bring a mortgage company your W-2s and pay stubs that show you have a good income. Therefore, your income for loan qualifying should be no problem, right? Well … not so fast.
The numbers on your W-2 forms could be negated by the tax deductions you take for job-related expenses. When you go to file your tax returns, your accountant may recommend maximizing your deductions to avoid higher taxes. No one wants to pay Uncle Sam, right? So many taxpayers take an extra deduction using "IRS Form 2106" expenses, many times unknowingly hurting their mortgage chances.
The IRS understands that because your employer may have an expense reimbursement policy or does not allow certain expenses to be refunded, you are permitted to write them off against your adjust gross income (AGI).
Commons expenses may include, but are not limited to:
Such costs may in fact be things that you're expected to pay for in your occupation.
However, banks don't care about that reasoning. From a lender's standpoint, if it's there, then it's counted.
Writing these off against your income reduces your qualifiable income, making you less mortgage-worthy. Why? Your income on your W-2 & pay stubs is not the whole picture. Your real income is lower because the 2106 expenses are taken out of income that is used to offset expenses including auto loan, credit card and student loan payments. Add to that your future housing payment, which comprises taxes, insurance, principal and interest, along with any other housing-related costs like a homeowners association or special assessment within the property taxes. (You use this calculator to see how much house you can afford.)
Lending on Unreimbursed Employee Expenses
Lenders know your real income is your gross wages pre-tax, less 2106 expenses. Let's say you have earned $100,000 per year of income, a nice salary of $8,333 per month, pre-tax, which is what lenders use to qualify you to take on a mortgage payment.
In addition, let's say your employer mandates employees to pay for their own tools, dues and licensing. For the past two years, you have taken a $15,000 per year of unreimbursed employee business expenses, $30,000 per year collectively for the most recent last 24 months. Broken down monthly, that's $1,250 coming off your gross income.
In this example the lender would use $7,083 in income, instead of making you less credit-worthy, especially if you're trying to take on a mortgage and accommodating other debt payments.
Expect lenders to average 2106 expenses derived from your federal income tax returns for the past two years. If, in the previous year, you didn't take 2106 expenses and then on the most recent taxable year you do take 2106 expenses, these numbers will be averaged by 12 months rather than 24.
The illogical aspect here: You make your mortgage payment with after-tax dollars based upon your gross income on a monthly basis, not taking into consideration these additional write-offs at the end of the year to pump up your refund. However, the lender still must err on the side of caution by factoring in these expenses even though you might have a proven ability to take on a higher mortgage payment coupled with your other monthly obligations. This is because when it comes down to it, it still negatively adjusts your income at loan decision time.
The Continuance Factor
Lenders want to make loans, but by the same token, they also want to cover their backside to avoid having to repurchase a loan because of an underwriting oversight.
If you can demonstrate and explain why you don't expect to have these expense deductions in the future, you improve your loan chances. The key is: Your explanation must hold water and be supported on paper.
If, for example, your employer changed their expense reimbursement policy or you now have a different title where you no longer need to take these expenses anymore. Or, perhaps you're no longer working full-time due to an injury and are on permanent disability income. Such scenarios would allow previous 2106 expenses to be omitted from your mortgage approval.
However, be prepared to show detailed supporting documentation. Moving forward, there must be an obvious reason or some sort of change in order for the lender to not count these expenses against your income.
If, due to your unique circumstances, you have to take these expenses as per the advice of your qualified tax professional, here are some considerations to be aware of.
- If you carry consumer debt such as car loans, credit card debt and student loans and are considering taking 2106 business expenses…
- Then how much of these 2106 expenses you claim on your tax returns becomes even more important. As a general rule, keep the 2106 annualized figures to no more than 5% of your gross income.
- If you don't carry consumer obligations or any other debt other than housing…
- Then you may have some more allowances with the amount of expenses you can write off against your income. Talk to a tax professional and lender.
The situation to avoid at all costs is taking on a mortgage payment that, combined with your other non-housing payments, is at 45% of your income (before factoring in 2106 expenses) and hoping the math will automatically work in your favor.
If you're in the above scenario, you may have to make some of the following concessions:
- Reduce your loan amount and/or purchase price of the property
- Reduce your fire insurance premium (which seems trivial, but in my experience this has saved multiple transactions)
- Reduce the interest rate on your loan by paying upfront in the form of points to generate a lower payment
- Pay off your car loan, or credit card balance or any other obligation eating into your income
- Put more money down
- Change loan programs
- Get a co-signer
Ultimately, if the amount of mortgage you are trying to qualify for becomes too much with your debt load, you will need to make some adjustments. Ask your lender for advice on how to manage your debts to help you qualify, or get a second opinion from another mortgage broker.
Furthermore, it can help you to work toward, or maintain, a strong credit score during this time. A better credit score can help you qualify for lower interest rates, which can give you more buying power. Keeping an eye on your credit standing can help you know where you stand, and to figure out whether you need to take action that will strengthen your credit. You can watch your progress by getting your monthly free credit report summary on Credit.com.
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