Owing the IRS can complicate your life in ways you may not even realize. For example, if you want to buy a new home, but have back taxes, you may find it difficult to secure a mortgage. This is especially true if the IRS has a tax lien in place. Although navigating the home-buying process can be challenging with tax debt, it’s not impossible. It just requires some careful planning and proactive financial management.
Will Tax Debt Prevent You From Buying a Home? Fact vs. Fiction
Although tax debt can undoubtedly pose challenges when purchasing a new home, it’s essential to separate fact from fiction. In this section, we’ll debunk some common myths surrounding tax debt and home buying.
Myth 1: Having Tax Debt Automatically Disqualifies You From Getting a Mortgage. Reality: Although tax debt can make it more difficult to secure a mortgage, it doesn’t necessarily preclude you from being approved. Lenders evaluate each case individually, taking into account factors such as the amount of debt, your overall credit profile, and your ability to manage financial obligations.
Myth 2: You Can’t Buy a Home Until Your Tax Debt is Paid in Full. Reality: Although it’s ideal to resolve tax debt before applying for a mortgage, some lenders may consider your application if you have an active payment plan in place with the IRS and have been consistently making payments for a specified period. VA loans, for example, require a minimum of 12 consecutive payments before they’ll consider your application.
Myth 3: Tax Debt Only Affects Your Mortgage Application if There’s a Tax Lien. Reality: Even without a tax lien, outstanding tax debt can still negatively impact your creditworthiness and debt-to-income ratio (DTI), which are crucial factors in mortgage approval.
How Tax Debt Affects Mortgage Approval
Owing back taxes doesn’t automatically disqualify you from obtaining a mortgage. However, unresolved tax debt can complicate the approval process. Lenders assess your financial responsibility, and outstanding tax obligations may raise concerns about your ability to repay a home loan.
1. Impact on Creditworthiness
Although tax debt itself might not appear on your credit report, the IRS can file a Notice of Federal Tax Lien, which becomes public record. This lien indicates the government’s legal claim against your property, signaling to lenders that you’re a higher-risk borrower. Such liens can hinder your ability to secure favorable mortgage terms or even lead to loan denial.
2. Debt-to-Income (DTI) Ratio Considerations
Lenders evaluate your DTI ratio to determine your ability to manage monthly payments. Tax debt increases your total obligations, potentially pushing your DTI ratio beyond acceptable limits. Maintaining a lower DTI ratio is crucial for mortgage approval.
3. IRS Payment Plans and Lender Perception
Establishing a formal payment plan with the IRS demonstrates your commitment to resolving tax debt. Lenders view this positively, especially if you’ve made consistent, on-time payments for at least three months. Documentation of this agreement and payment history can bolster your mortgage application.
Strategies to Improve Mortgage Approval Chances
If you’re planning to buy a new home but owe the IRS, there are some steps you can take to help increase your chances of getting a loan.
- Settle Tax Debt Before Applying. Paying off your tax debt in full eliminates potential red flags for lenders. It also prevents the IRS from placing liens on your property, simplifying the mortgage process.
- Enter an Installment Agreement with the IRS. If immediate full payment isn’t feasible, negotiate an installment agreement. Ensure you adhere to the payment schedule, as consistent payments over several months can positively influence lender decisions.
- Consider FHA Loans. Federal Housing Administration (FHA) loans are more lenient regarding tax debt. If you have a payment plan in place and meet other criteria, such as a satisfactory credit score and DTI ratio, you may still qualify for an FHA loan.
Dealing With Tax Liens
A tax lien significantly complicates the home-buying process. Lenders are hesitant to approve mortgages when the IRS has a legal claim on your assets. To address this:
- Pay Off the Lien: Settling the debt removes the lien, clearing the path for mortgage approval.
- Request Lien Subordination: The IRS may agree to subordinate its lien, allowing your mortgage lender to take primary claim over the property. This doesn’t remove the lien, but it can make lenders more willing to approve the loan.
Final Thoughts
Although owing the IRS presents challenges in buying a home, it’s not an insurmountable obstacle. By proactively managing your tax debt, maintaining open communication with lenders, and exploring flexible loan options like FHA loans, you can increase your chances of securing a mortgage. For personalized strategies tailored to your specific financial situation, consult with a tax professional or a mortgage advisor.