Our tax expert reveals the mysterious relationship between your money and the tax system
…and what it means for you!
Dear Marilyn,
I recently heard that for small businesses/sole proprietorships, writing off too much on your taxes can result in not being able to secure a bank loan. Is this true? …and if so, WHY? My credit is still good. My taxes are all legit (I didn't take any shady deductions). Does this mean I have to wait until next year to buy a house? Help!
Marilyn Parham, C.P.A.: Before we get started, I need you to breathe.
Are you breathing? Okay.
It is true that when it comes to loaning money, banks tend to give the side-eye to small businesses and sole entrepreneurships. This will apply for most any loan you are seeking, not just home loans.
Wait…So I Deducted Too Much?
That implies that your deductions weren't legitimate, and I'm sure they were.
The thing to understand is that, as small business owners and sole proprietors, we need to think in terms of taxable income and net income.
[Tweet “As small business owners, we need to think in terms of taxable income and net income. #TheBottomLine”]Banks will request and care about your “taxable income,” but your “net income” carries the most weight.
Net income is the income that your business generates before any “taxable” deductions you can take due to your self-employed status.
The thing is, banks like security. If your business is not showing a decent and consistent profit, the bank will question if you can make payments on your loan. (That's just how they roll.)
Banks also like W2 wage earners a lot better than self-employed earners. This is because W2 earners have set and consistent earnings. As we all know, self-employed earners don’t have set earnings; they could go under more easily and quickly than an employee can lose their job.
So there is always a double edge to the small business/sole proprietorship life.
From a tax perspective, you want to take advantages of all deductions that you can because that means you pay less taxes.
From a banking perspective, you want to show a decent profit because that will allow you to have better credit.
[Tweet “Small business life has two sides: the tax perspective and the banking perspective.”]So What Can I Do?
It is my opinion that you should just be accurate and let the numbers speak for themselves. It's really not about how much you do or don't write off. It's about keeping outstanding books that prove you're on top of your business' numbers.
If you are keeping your accounting on an Excel spreadsheet, that isn’t going to show “reliability” to your banker. A lot of bookkeeping systems don't keep track of assets and liabilities the way a full entry accounting system will do. Show the bank that you are informed and invested in the numbers of your business.
[Tweet “Bank Loans 101: Show that you are informed and invested in the numbers of your business.”]Some other things to do are to keep certain things out of your accounting system:
- Charitable contributions are great and I love them, but take them on your personal tax return instead.
- If you can take additional tax deductions (like mileage and home office deduction) on your tax return, your accounting records should not reflect those.
- If you are paying for health insurance or retirement, don’t show these as a business deduction.
These are all legit things to write off, but don’t expense them as part of your business if you want your income to look better.
Get Professional Help
Lastly, get someone who is knowledgeable in business and accounting to look over your financial information before you give it to a banker, especially if you are new to this. You don’t want to give a banker an income statement that looks crazy and then go back and change it a few times before it’s “right.” That doesn’t make anyone feel confident of your accuracy.
[Tweet “Get a knowledgeable accountant to look over your financial info BEFORE you apply for a loan.”]What You Can Do This Year
If you're a small business owner who just filed your taxes, it doesn't mean you can't apply for a home loan this year. Here's what you can do to move the process forward:
- If you didn’t have a good set of accounting books, then put one together. At the very least, create a good-looking report by taking your tax return business income and expenses and putting them in a spreadsheet.
- Make sure everything looks nice and adds up correctly.
- Don’t include the “tax deductions” that I mentioned before, like mileage and home office deductions.
- Make sure that you print it out in PDF form and ensure it looks professional.
- Then make sure your 2016 bookkeeping is up to date because the bank will almost assuredly ask you for it.
The Bottom Line
You don't have to choose between owning a small business and owning a home. Good accounting records (on a reliable full entry accounting system) will help you obtain that loan.
