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Question
The more business expenses I deduct, the lower my income will look on paper, right? Will taking too many write-offs make it hard for me to take out a loan and get financing?
Answer

Great question! The short answer is yes,. However, it’s not necessarily that black and white. When a lender is trying to calculate your debt-to-income (DTI) ratio, they are going to consider a couple of things:

  1. Schedule C net income. Generally speaking, lenders are going to look primarily at your Schedule C net income to verify your cash flow. There are several large tax deductions available to freelancers that adjust taxable income on your 1040, but that don’t lower your net income on your Schedule C. Examples would be SEP and Solo 401k contributions and self employed health insurance. These deductions dramatically reduce your taxable income but will probably not hurt your chances of securing credit.
  2. Actual cash flow. Lenders are trying to determine risk — how likely it is you will be able to make payments — so cash flow is king. To that end, they usually make adjustments to your Schedule C to remove on “paper only” write-offs like accelerated depreciation and home office deductions. Creditors are aware that tax deductions aren’t always the same as actual expenses. The flip side of this is that they will also add back expenses that were removed for tax purposes, like the 50% of meal costs that were excluded by the IRS.
  3. Trend analysis. In most cases, lenders will want to see several years of your tax returns to assess the trend in your income. Ideally, income should be going up every year. However, there will be years where your income drops considerably because of large purchases. For instance, you might prepay insurance or purchase machinery and equipment. Those will be items worth noting for your underwriter because they aren’t recurring large expenses. So even though they hurt your cash flow this year, they probably won’t next year.

Every financial institution has their own credit policy and risk appetite, so it’s worth shopping around. A “no” at one place might be a “yes” at another. Establishing a good credit history will do a lot to tip the scales in your favor.

At the end of the day, if your expenses make your net income too low to qualify for a loan, manipulating the picture on your tax return is not in your best interest. It will be more advantageous in the long-run to take advantages of the tax breaks available to you than to sign-on to a loan you can’t pay back and risk jeopardizing your business assets in the process.

It’s worth noting that qualifying for a loan is not the same as qualifying for a good loan. Odds are, if you have to exclude business write-offs just to get in the door, the only loans you’ll be able to get will have high interest rates and steep penalties.

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Sarah York, EA

Sarah is a staff writer at Keeper Tax and has her Enrolled Agent license with the IRS. Her work has been featured in Business Insider, Money Under 30, Best Life, GOBankingRates, and Shopify. She has nearly a decade of public accounting experience, and has worked with clients in a wide range of industries, including oil and gas, manufacturing, real estate, wholesale and retail, finance, and ecommerce. Sarah has extensive experience offering strategic tax planning at the state and federal level. During her time in industry, she handled tax returns for C Corps, S corps, partnerships, nonprofits, and sole proprietorships. Sarah is a member of the National Association of Enrolled Agents (NAEA) and maintains her continuing education requirements by completing over 30 hours of tax training every year. In her spare time, she is a devoted cat mom and enjoys hiking, baking, and overwatering her houseplants.

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