The Nitty and Gritty about Rental Income

Rental income, what it is, when it can be used, how its calculated, how it can benefit, and the pitfalls are all explained below.

Rental income is income from a property that a borrower owns. It can be 1-4 Residential or even 5+ unit apartment buildings, or commercial, etc..

Rental Income discussed below mainly pertains to conventional financing with freddie mac and fannie mae guidelines (not FHA, not VA, or commercial 5+ units).

The rental income info below refers to properties about to be purchased or refinanced. However, after tax returns are filed (post acquisition) the rental income claimed on your prior 1-2 years tax returns are used to calculate the positive or negative income on your loan qualification (not a topic of this blog but its important as well - how to read tax returns for rental income).

Rental income can be used when its legally allowed by zoning so as an example a 4 unit property or fourplex where the owner occupies one unit and has 3 other legally allowed units can use the rental income on 3 units to help in the income qualification. The "key," for how the rental income is calculated depends on whether the borrower is an " primary occupant," or if the borrower is a "non owner occupant," as you'll see the most advantageous method of calculation is for the non owner occupant, explained later on below.

Some common examples where rental income cannot be used:

-Single Family Home with a guest house in the back, while it can be rented is only a 1 unit legal residence so rental income cannot be used when the owner is an occupant in the home so this income while received in the real world is not able to be used while the borrower is a primary occupant (it can be used if the borrower were to rent out the main home and the guest home)

- boarder income or "room mate," income cannot be used to income qualify when youre living in a home as a primary occupant even though you're actually receiving money. There are some niche programs that may allow the use of this income but only in rare cases such as when you have an elder caretaker lives with you to reimburse you for their stay (medical) or on specific first time buyer programs (very rare).

- unpermitted subject properties - a single family home that legally zoned for 1 unit that is split into 3 units and trying to count rental income on all 3 units cannot be used for qualification (it may be used if its not the subject property meaning if its a rental on your tax return but its not the subject property you're getting a loan on)

Rental income atleast with respect to Fannie Mae and Freddie Mac is calculated at 75% of gross monthly subtracted from the PITIA ( the monthly payment for principal interest taxes insurance and assessments). So if gross rents were 1500 and PITIA was 1000 then you'd receive a net monthly cash flow of + $125 to income (75% of 1500 = $1125- 1000 = 125).

How the income is calculated and why its relevant depends on the "occupancy:"

- When you're an Owner Occupant ( living in one unit of the fourplex and renting out 3 units) the rental income number of 1125 above is not subtracted from the total monthly payment (PITIA) to yield a net positive or negative number. Only a fraction (usually 45% debt to income DTI) of this 1125 can be used to qualify. To keep the example simple 45% of 1125 is  506.25 so that means when you're an owner occupant of one unit you basically have to come in with some income yourself in order to qualify for this loan because the remaining payment $493.75 is left ( $1000 per month PITIA above - 506.25 of "usable income" calc above = 493.75 that you need to qualify for yourself).

- When you're a Non Owner Occupant (not claiming you're going to live at the property) the calculation is the most beneficial because its calculated as $1125 (net rental income - $1000 (pitia) = +125 to income and the property is considered positive income so it actually adds to your total income. This "income," when the property is underwritten as a non owner occupied property can be used to qualify for other liabilities so in theory  if a borrower kept buying non owner properties that resulted in a positive net income when using 75% of gross income - PITIA then the qualifying income would grow up to a point where the borrower may no longer need a "job," to qualify for a conventional loan because the rental income could replace or subplant the need for that regular salary.

 There are strategies that allow only 1 year tax returns for rental income instead of having to average 2 years of rental income but will need mortgage planning in advance to achieve. Its important to plan the rental income and how its claimed ahead of when you need to qualify for a loan because the way a lender calculates your rental income may not exactly be what you had in mind.

Rental income calculations within LLC's and entities are also calculated differently than rental income in the borrowers name (freddie mac). The advantages are skewed in the favor of using LLC's atleast when it comes to conventional loans sold to freddie mac as the calculation is more generous.

 This is a more complex topic so if you have any questions feel free to let me know.