How to Calculate Tenant Income from Real Estate Investments
by Daniel Bagliore
During the move-in or recertification process, you may encounter households that own real estate such as a single-family home or a residential building. The Section 8 program doesn’t bar subsidized tenants from owning a home or other real estate. However, in accordance with the lease and program eligibility requirements, the household must reside in the Section 8 unit as their sole place of residence. In addition, when calculating rent, owners are required to treat the real estate as an asset, determine its cash value, and consider any income generated by the real estate.
To determine income from real estate, as with any asset under the HUD program, the owner will use the greater of the actual income generated by the household’s assets or the imputed income from the household’s assets when the cash value of all household assets exceeds $5,000 [HUD Handbook 4350.3, par. 5-7(F)(1)].
The following formula is used to calculate actual or net income from real estate:
Gross Rental Income – Expenses – Interest on Qualified Loans = Net Income
The owner should work with the household to make a reasonable judgment in projecting the household’s real estate income and expenses for the year following the certification effective date. We’ll go over all the elements in the formula necessary to reach an accurate figure for your tenant rent calculations.
Gross Rental Income
Your tenant may rent his or her home or other property (in whole or in part) to one or more persons (or commercial entities). The rent revenue received by your tenant is considered the gross rental income.
To calculate the gross rental income, owners may utilize various documents, such as a current lease, recent rent checks, or the latest IRS Schedule E (Supplemental Income and Loss) [HUD Handbook 4350.4, Appendix 3]. A current lease is probably the most reliable document since it will identify the current rent level established for the apartment, which can be annualized to determine gross rental income for the next 12 months following the certification effective date.
Example: During the annual recertification, your tenant, a property owner, provides the current lease with her tenant identifying the current monthly rent as $1,000. Therefore, gross rental income is $12,000 ($1,000 x 12 months). Should a lease be unavailable, the owner may rely on rent checks (if available) to determine monthly rent revenue.
The most recent IRS Schedule E is another option. However, this document will provide previous rent revenue information and may not be the best predictor of anticipated income.
Expenses, which are deducted from gross rental income, include ordinary expenses incurred in operating the property, such as costs for insurance premiums, advertising, cleaning, repairs, management fees, utilities, property taxes, and other expenses.
The household will need to document its real estate expenses, which can be verified with receipts, the most recent IRS Schedule E, contracts with vendors, or other acceptable paperwork.
The IRS Schedule E is a good place to start your real estate expense determination. But keep in mind that this document provides information on prior expenses and may not be the best tool to project some or all future expenses.
When possible, you should rely on documentation other than the IRS Schedule E that will identify the anticipated expenses for the 12-month period following the certification effective date as opposed to using prior information. However, in some cases, you may have no choice but to rely upon prior information to project anticipated expenses.
Example: During the annual recertification, your tenant provides the most recent IRS Schedule E, which reflects $2,000 in utilities, $1,500 in taxes, $1,450 in insurance, and $300 in repairs incurred during the prior tax year. Your tenant indicates the following:
- As there’s no expected change in utilities, a $2,000 utility expense based on the Schedule E will be included in the calculation.
- Property taxes are increasing $25 quarterly ($100 annualized), and the tenant provides a new tax bill as verification. So we’ll project property taxes of $1,600 ($1,500 + $100).
- The annual insurance premium will increase by $100 as evidenced by the recent paid invoice issued by the insurer. So we’ll project an expense of $1,550 ($1,450 + $100) for insurance.
- The $300 repair cost was incurred last year to fix the refrigerator, and no repairs are expected this coming year. As such, the repair cost won’t be counted.
Add all of the expenses together as follows:
We’ll project $5,150 in annual expenses to operate the property.
Your tenant may have accepted a mortgage loan from a bank or other lending institution to borrow funds to purchase the real estate. The loan must be repaid to the lender on a monthly basis, with varying portions allocated to principal and interest. Early in the repayment period, a higher percentage of the payment is applied to interest, while a higher portion of the payment is allocated to principal later in the loan period. The predetermined allocation of the monthly repayment is reflected in an amortization schedule provided by the lender.
In accordance with HUD rules, in addition to operating expenses, interest must also be deducted from the gross rental income; importantly, the principal portion of the monthly mortgage payment can’t be deducted and mustn’t be included in this calculation.
Upcoming interest payments can be ascertained from the amortization schedule. Simply add up the next 12 interest payments on the amortization statement from the certification effective date to obtain the anticipated annual interest expense.
For example, during the Oct. 1, 2019, annual recertification, we need to determine the upcoming interest expenses for the next 12 months. Using the amortization schedule provided by the tenant, starting from October 2019, add the next 11 upcoming monthly interest payments up to and including September 2020; the sum total represents the anticipated interest payments for the year following the certification effective date (Oct. 1, 2019 to September 2020) and, along with the operating expenses, is deducted from the rental revenue.
Should the amortization schedule be unavailable, you may rely on the interest payments included on Line 12 of the latest IRS Schedule E; however, you should insist on the submission of the amortization schedule.
The real estate income calculation is similar to the HUD rules that govern the net income formula for a self-owned business. However, income from the property owned by your tenant isn’t considered self-employment income unless real estate is the individual’s primary occupation, and, since the real estate is a household asset, as opposed to a business asset, depreciation isn’t allowed. In addition, like self-employment income, when net income from the property is negative, it can’t be used to offset other income and must be recorded as zero.
Put It All Together
Here’s an example of how to tie the real estate income calculation together:
Example: Your tenant is recertifying for her Nov. 1, 2019, annual recertification and provides the current lease with her tenant, the 2018 IRS Schedule E, and the amortization schedule for her mortgage loan.
The lease is effective from Sept. 1, 2019, to Aug. 31, 2020, and reflects the monthly rent as $1,500. Although the lease expires during the recertification period, your tenant confirms that she’ll probably renew the lease with her tenant at the same monthly rate upon expiration. Therefore, gross rental income will be calculated as $18,000 ($1,500 x 12 months).
The 2018 IRS Schedule E indicated that your tenant spent $400 on advertising, $2,000 on insurance, $1,700 on taxes, and $500 on cleaning and maintenance. Your tenant explains that the $500 cleaning and maintenance expense was incurred in 2018 to clean the apartment when her prior tenant moved out and that she spent the $400 to advertise the apartment’s availability; since she intends to retain her current tenant, she doesn’t expect to incur either aforementioned expense during the next year.
The $2,000 insurance premium is expected to remain the same for the next year, and your tenant provides an invoice from the insurer to demonstrate this. Property taxes are paid twice a year, and your tenant provides her recent tax bill that reflects a $50 increase in the annual property tax. Therefore, the total property tax expense will be $1,750 ($1,700 + $50) for the next year.
Your tenant also provides a contract to demonstrate that she has hired a contractor to replace the floor in the bedroom at a cost of $1,000 in November 2019. Therefore, this anticipated $1,000 payment will be included in the expense calculation.
Total anticipated expenses from operating the real estate is $4,750 ($2,000 for insurance, $1,750 for property taxes, and $1,000 for floor replacement). Finally, a review of the amortization schedule reveals that your tenant is expected to pay the lender a total of $7,400 in interest payments from September 2019 to August 2020.
The net Income from real estate will be calculated as:
$18,000 (Gross Rental Income) - $4,750 (Expenses) - $7,400 (Interest) = $5,850 (Net Income)
Therefore, the net income of $5,850 from owning real estate will be included in the household’s asset income calculation. Asset income will be calculated as the greater of the actual income generated by, or the imputed income of, all household assets.
Of course, after the annual recertification, your tenant may request an interim recertification to reflect a documented reduction in gross rental income (for example, if the tenant vacated the leased premises) and/or an increase in expenses (such as emergency roof repairs) that may lower the net income from the asset and reduce the tenant’s subsidized rent. On the other hand, your tenant is required by HUD to report for an interim recertification when income from assets (for example, if the vacant apartment is now leased) increases household income by $200 or more per month. Again, it’s important to work with your tenant to make reasonable judgments concerning real estate income and expenses during the interim recertification process.
Daniel Bagliore is Director of Compliance, Unithree Investment Corp., 240 Park Hill Ave., Staten Island, NY 10304.