Purchasing Power and Self Employed Tax Deductions
By: Selene Garcia
With tax season upon us, a self-employed person can become a bit over-zealous when taking advantage of tax deductions. While those deductions are available to you, you must be clear about the impact of those deductions before taking advantage of every available shelter.
You see, while the tax advantages of owning a business help lower your tax liability, those same advantages also impact your home buying power…deductions equate to less income.
Let’s better understand how your income and deductions are reported.
Where in my returns can I find income?
Where in my returns can I find deductions?
Schedule C deductions: Expenses on the Schedule C can be found in Part II of the form. Schedule C expenses are deducted from your income and shield that portion of your income from being taxed (remember, you can’t use non-taxed earnings). There is, however, an exception, depletion and depreciation (lines 12 and 13) can be added back into your gross income found on line 7 of your Schedule C.
Schedule E deductions: Remember this is a two-page form; the first page is meant for real estate and the second page is meant for business income or loss carried over from your K1.
- Real Estate – In part I of the Schedule E you will see property you own, the type of property and all of the annual income and expenses associated with that piece of real estate. All of the expenses listed are deducted from your income (except for depreciation and depletion).
- Business – In part II of the Schedule E you will see businesses you own, the type of business, the type of income or loss from your K1 and your total income on line 32.
Below are common expenses of the self-employed. Let’s look at some ways you can offset your personal liability:
Business Car Payments
If you are using your vehicle for your business and your business has made at least twelve of the monthly payments, this monthly payment will not be used when calculating your monthly debt ratio (DTI). Just know, you will be asked for proof of the twelve payments; this is not a way to shirk the system.
Using business credit is acceptable and, like your business vehicle, the monthly payment will not be used to calculate your monthly debt. Again, you will need to show proof of all twelve payments made by the business directly to the credit card.
If you are using a percentage of your home to run your business you can deduct that percentage of square footage. Be sure and know the rules for home office deduction before pulling out your tape measure.
How do deductions impact my buying or refinancing power?
Here’s the most straightforward scenario:
- You are a business owner of a Sole Proprietorship.
- All of your business income (along with any losses) is shown on the Schedule C of your federal tax return.
- In one year you earn $60,000 – this shown at the top of your Schedule C.
- In this same year, you’ve taken $10,000 in losses – this is shown at the bottom of your Schedule C.
Gross Annual Income: $60,000
Annual Loss: $10,000
Let’s break it down further and look at monthly figures:
Gross Monthly Income: $5,000
Monthly Loss: $833
Gross Monthly Income Used for Your Mortgage: $4,167
So how does this impact your purchase price?
Because debt-to-income ratios are used to qualify you for a loan some assumptions need to be made simply to create an apples-to-apples comparison:
- Monthly Property Taxes: $208
- Monthly Property Insurance: $75
- The rate used for this purpose is no higher than 4.5 percent.
- You are putting down 20 percent.
- You have no other debt such as car payment, credit cards, student loans, additional real estate etc.
- Credit score of at least 700.
Monthly Income: $5,000
Purchase Price: $450,000
Monthly Income: $4,167
Purchase Price: $385,000
This is a notable difference – to the tune of $65,000.
The bottom-line? Be mindful of your deductions for two federal tax seasons prior to buying a home.
Understand, self-employed income can become quite a bit more complicated and this example is simply meant to show the impact of your deductions.
If you have found yourself in this situation, all hope is not lost. You can always amend your taxes allowing you to adjust your deductions and show more income.