What happens to income from non-conforming units?

Question

Property is zoned duplex, but has an additional mother in-law situation that is rented. So three tenants with three leases, but only zoned for a duplex. Very unlikely the city will care. Is there any creative way the income from that extra "sublet unit" can be applied towards my own?

Tim Swierczek · Answer

@Noah P Bonds As a lender we would look at the income differently based on the transaction, this answer assumes a traditional loan product such as conventional, FHA, VA, or USDA there are portfolio products that would treat this income differently.

The distinction would be if the income would not be used at the purchase of the property, lenders on traditional products will not use the income from legal units, because that income can not be relied on.  For example, the city could prevent you from renting it in the future and in extreme cases, a repeat offender could lose the rental license.  That is not common but it can happen and lenders have no incentive to take on the risk that a borrower must use the uncertain income to qualify.  They will not prevent you from receiving the income just from using it to qualify.

The other situation is how this income will be used for future qualifications.  The simple answer is the lender will use the income that you claim on your schedule E + the depreciation which loan guidelines do not consider a true expense (this is good for investors).  To be correct we use the following form.  If you were to look at your schedule E and put the info into this format it will show you the exact calculation.  if the Net Monthly Rental income is positive the income will help you, a loss will be deducted from your employment income.

Noah P Bonds · Answer

@Adam Gollatz

Thanks Adam, I think that hits the nail on the head. I’ve been confused by what lenders say about income and how they can’t really include income from non-conforming units...but in the big picture it still helps your dti. Like I wasn’t seeing the debt forest for the debt tree... spoken with the city about several of these situations and they’re not going after them for now. Just too many of them. I’m not sure about the 2040 - I’ll check I out.

Adam Gollatz · Answer

You are talking about 2 different things here, local zoning laws and Federal/State tax laws. If you gain income from something, you have to claim it. If you claim it, then it makes your DTI better and helps you toward buying more properties. You could run a daycare out of your house and as long as you pay taxes, the irs isnt going to come knocking, it will be the city. Vice versa, you can run a legal day care out of a building and if you dont pay taxes, the city wont care, it will be the irs that comes.

With that being said, the 2040 plan is taking effect soon. Will your property fall into that?

Noah P Bonds · Answer

Alan - thanks for the reply. Yeah certainly don't want to go there. Please don't imply I'm trying to lie. I'll try and explain a bit more: What I'm wondering is how does that non-conforming income help you buy more properties later on? As in how can you use that income as leverage in the future if a lender disregards it? Lenders won't count it as income on the loan application, but when I claim the income on a per property basis on my taxes doesn't that in turn increase my borrowing power the next year?  I guess I'm wanting to make sure the income still helps me in the future.

Alan Grobmeier · Answer

@Noah P Bonds, probably not.  What you are basically asking is:  Is it ok to lie to the IRS.  That answer is 'not only no, but hell no'.  ;-)

If you are using schedule E for your rentals, you will need to claim the income & expenses on a per property basis.  Not a per unit basis.  Transferring income & expenses, especially to avoid taxes, is 'frowned' upon at the IRS.

In any event, I would find a CPA if I were you.  He will keep you on the straight & narrow and out of the bullseye of the IRS.  ;-)

Hope that helps.

What happens to income from non-conforming units?

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