B3-3.1-08, Rental Income (10/04/2023)

In conjunction with the policies in this topic, lenders must also comply with, as applicable, but not limited to, the policies in the following:

• B2-2-03, Multiple Financed Properties for the Same BorrowerB2-2-03, Multiple Financed Properties for the Same Borrower;

• B3-3.1-01, General Income InformationB3-3.1-01, General Income Information (Continuity of Income);

• B3-3.5-02, Income from Rental Property in DUB3-3.5-02, Income from Rental Property in DU;

• B3-4.1-01, Minimum Reserve RequirementsB3-4.1-01, Minimum Reserve Requirements; and

• B3-6-06, Qualifying Impact of Other Real Estate OwnedB3-6-06, Qualifying Impact of Other Real Estate Owned.

Rental income is an acceptable source of stable income if it can be established that the income is likely to continue. If the rental income is derived from the subject property, the property must be one of the following:

• a two- to four-unit principal residence property in which the borrower occupies one of the units, or

• a one- to four-unit investment property.

If the income is derived from a property that is not the subject property, there are no restrictions on the property type. For example, rental income from a commercial property owned by the borrower is acceptable if the income otherwise meets all other requirements (it can be documented in accordance with the requirements below).

Generally, rental income from the borrower’s principal residence (a one-unit principal residence or the unit the borrower occupies in a two- to four-unit property) or a second home cannot be used to qualify the borrower. However, Fannie Mae does allow certain exceptions to this policy for boarder income and properties with accessory units. See B3-3.1-09, Other Sources of IncomeB3-3.1-09, Other Sources of Income, for boarder income requirements, and B5-6-02, HomeReady Mortgage Underwriting Methods and RequirementsB5-6-02, HomeReady Mortgage Underwriting Methods and Requirements, for accessory unit income requirements.

If a borrower has a history of renting the subject or another property, generally the rental income will be reported on IRS Form 1040, Schedule E of the borrower’s personal tax returns or on Rental Real Estate Income and Expenses of a Partnership or an S Corporation form (IRS Form 8825) of a business tax return. If the borrower does not have a history of renting the property or if, in certain cases, the tax returns do not accurately reflect the ongoing income and expenses of the property, the lender may be justified in using a fully executed current lease agreement. Examples of scenarios that justify the use of a lease agreement are

• purchase transactions where there is an existing lease on the property that will transfer to the borrower;

• refinance transactions where the borrower purchased the rental property during or subsequent to the last tax return filing;

• refinance transactions for a property that experienced significant rental interruptions causing income to not be reported on the most recent tax return (for example, major renovation to a property occurred in the prior year that affected rental income); and

• transactions where rental income is being used to qualify for any property placed in service in the current calendar year, for example, when converting a principal residence to an investment property.

When the subject property will generate rental income and it is used for qualifying purposes, one of the following Fannie Mae forms must be used to support the income-earning potential of the property:

• For one-unit properties: Single-Family Comparable Rent Schedule (Form 1007) (provided in conjunction with the applicable appraisal report), or

• For two- to four-unit properties: Small Residential Income Property Appraisal Report (Form 1025).

Note: The rental payment on the lease must be reflected in U.S. dollars (cannot be in virtual currency).

The lender must obtain documentation that is used to calculate the monthly rental income for qualifying purposes. The documentation may vary depending on whether the borrower has a history of renting the property, and whether the prior year tax return includes the income.

Note: All references in this table to lease agreements and Form 1007 or Form 1025 must comply with the requirements in Lease Agreements, Form 1007, or Form 1025.

If the borrower is not using any rental income from the subject property to qualify, the gross monthly rent must still be documented for lender reporting purposes. See Reporting of Gross Monthly Rent below for details.

When the borrower owns property – other than the subject property – that is rented, the lender must document the monthly gross (and net) rental income with the borrower’s most recent signed federal income tax return that includes Schedule 1 and Schedule E. Copies of the current lease agreement(s) may be substituted if the borrower can document a qualifying exception. See Reconciling Partial or No Rental History on Tax Returns below and Calculating Monthly Qualifying Rental Income (or Loss).

In order for the lender to determine qualifying rental income, the lender must determine whether or not the rental property was in service for the entire tax year or only a portion of the year. In some situations, the lender’s analysis may determine that using alternative rental income calculations or using lease agreements to calculate income are more appropriate methods for calculating the qualifying income from rental properties. This policy may be applied to refinances of a subject rental property or to other rental properties owned by the borrower.

If the borrower is able to document (per the table below) that the rental property was not in service the previous tax year, or was in service for only a portion of the previous tax year, the lender may determine qualifying rental income by using

• Schedule E income and expenses, and annualizing the income (or loss) calculation, or

• fully executed lease agreement(s) to determine the gross rental income to be used in the net rental income (or loss) calculation.

If the borrower is converting a principal residence to an investment property, see B3-6-06, Qualifying Impact of Other Real Estate OwnedB3-6-06, Qualifying Impact of Other Real Estate Owned, for guidance in using that rental income to qualify the borrower.

Rental income must be calculated for each rental property. To determine the amount of monthly rental income from each property that can be used for qualifying purposes, the lender must consider the following:

The lender must establish a history of property management experience by obtaining one of the following:

• The borrower’s most recent signed federal income tax return, including Schedules 1 and E. Schedule E should reflect rental income received for any property and Fair Rental Days of 365;

• If the property has been owned for at least one year, but there are less than 365 Fair Rental Days on Schedule E, a current signed lease agreement may be used to supplement the federal income tax return; or

• A current signed lease may be used to supplement a federal income tax return if the property was out of service for any time period in the prior year. Schedule E must support this by reflecting a reduced number of days in use and related repair costs. Form 1007 or Form 1025 must support the income reflected on the lease.

Note: The requirements in Calculating Monthly Qualifying Rental Income (or Loss) do not apply to HomeReady loans with rental income from an accessory unit.

Method for Calculating the Income

The method for calculating rental income (or loss) for qualifying purposes is dependent upon the documentation that is being used.

Federal Income Tax Returns, Schedule E. When Schedule E is used to calculate qualifying rental income, the lender must add back any listed depreciation, interest, homeowners’ association dues, taxes, or insurance expenses to the borrower’s cash flow. Non-recurring property expenses may be added back, if documented accordingly.

If the property was in service

• for the entire tax year, the rental income must be averaged over 12 months; or

• for less than the full year, the rental income must be averaged over the number of months that the borrower used the property as a rental unit.

See Treatment of the Income (or Loss) below for further instructions.

When current lease agreements or market rents reported on Form 1007 or Form 1025 are used, the lender must calculate the rental income by multiplying the gross monthly rent(s) by 75%. (This is referred to as "Monthly Market Rent" on the Form 1007.) The remaining 25% of the gross rent will be absorbed by vacancy losses and ongoing maintenance expenses.

When using a lease agreement, the lease agreement amount must be supported by

• Form 1007 or Form 1025, as applicable, or
• evidence the terms of the lease have gone into effect. Evidence may include:
  • two months consecutive bank statements or electronic transfers of rental payments for existing lease agreements, or
  • copies of the security deposit and first month's rent check with proof of deposit for newly executed agreements.

See Treatment of the Income (or Loss) below for further instructions.

The treatment and amount of monthly qualifying rental income (described above in Calculating Monthly Qualifying Rental Income (or Loss)) used in the calculation of the borrower's total debt-to-income ratio — varies depending on whether the borrower occupies the rental property as their principal residence.

If the rental income relates to the borrower’s principal residence:

• The monthly qualifying rental income (as defined above) must be added to the borrower’s total monthly income. (The income is not netted against the PITIA of the property.)

• The full amount of the mortgage payment (PITIA) must be included in the borrower’s total monthly obligations when calculating the debt-to-income ratio.

If the rental income (or loss) relates to a property other than the borrower's principal residence:

• If the monthly qualifying rental income minus the full PITIA is positive, it must be added to the borrower’s total monthly income (subject to the limits in Calculating Monthly Qualifying Rental Income (or Loss)).

• If the monthly qualifying rental income minus PITIA is negative, the monthly net rental loss must be added to the borrower’s total monthly obligations.

• The full PITIA for the rental property is factored into the amount of the net rental income (or loss); therefore, it should not be counted as a monthly obligation.

• The full monthly payment for the borrower's principal residence (full PITIA or monthly rent) must be counted as a monthly obligation.

Note: When a borrower owns multiple rental properties, the rental income for all non-subject properties is first calculated for each property, then aggregated. The aggregate total of the income (or loss) is then added to the borrower's total monthly income or included in their monthly obligations, as applicable.

If the borrower is personally obligated on the mortgage debt (as evidenced by inclusion of the related mortgage(s) on the credit report) and gross rents and related expenses are reported through a partnership or S corporation, the business tax returns may be used to offset the property’s PITIA. The steps described below should be followed:

1. Obtain the borrower’s business tax returns, including IRS Form 8825 for the most recent year.

2. Evaluate each property listed on Form 8825, as shown below:

• From total gross rents, subtract total expenses. Then add back insurance, mortgage interest, taxes, homeowners’ association dues (if applicable), depreciation, and non-recurring property expenses (if documented accordingly).

• Divide by the number of months the property was in service.

• Subtract the entire PITIA (proposed for subject property or actual for real estate owned) to determine the monthly property cash flow.

3. If the resulting net cash flow is positive, the lender may exclude the property PITIA from the borrower’s monthly obligations when calculating the debt-to-income ratio.

4. If the resulting net cash flow is negative (that is, the rental income derived from the investment property is not sufficient to fully offset the property PITIA), the calculated negative amount must be included in the borrower’s monthly obligations when calculating the debt-to-income ratio.

In order to include a positive net rental income received through a partnership or an S corporation in the borrower’s monthly qualifying income, the lender must evaluate it according to Fannie Mae’s guidelines for income received from a partnership or an S corporation. See B3-3.4-01, Analyzing Partnership Returns for a Partnership or LLCB3-3.4-01, Analyzing Partnership Returns for a Partnership or LLC and B3-3.4-02, Analyzing Returns for an S CorporationB3-3.4-02, Analyzing Returns for an S Corporation.

Fannie Mae publishes four worksheets that lenders may use to calculate rental income. Use of these worksheets is optional. The worksheets are:

• Rental Income Worksheet – Principal Residence, 2– to 4–unit Property (Form 1037),

• Rental Income Worksheet – Individual Rental Income from Investment Property(s) (up to 4 properties) (Form 1038),

• Rental Income Worksheet – Individual Rental Income from Investment Property(s) (up to 10 properties) (Form 1038A), and

• Rental Income Worksheet – Business Rental Income from Investment Property(s) (Form 1039).

Eligible rents on the subject property (gross monthly rent) must be reported to Fannie Mae in the loan delivery data for all two- to four-unit principal residence properties and investment properties, regardless of whether the borrower is using rental income to qualify for the loan. If the borrower is using rental income from the subject property to qualify for the loan, all of the applicable requirements above must be followed to document and calculate the income.

If the borrower is not using any rental income from the subject property to qualify, gross monthly rent must be documented only for lender reporting purposes. The borrower can provide one of the sources listed above, or may provide one of the following sources (listed in order of preference):

• the appraisal report for a one-unit investment property or two- to four-unit property, or Single-Family Comparable Rent Schedule (Form 1007), provided neither the applicable appraisal nor Form 1007 is dated 12 months or more prior to the date of the note;

• if the property is not currently rented, the lender may use the opinion of market rents provided by the appraiser; or

• if an appraisal or Form 1007 is not required for the transaction, the lender may rely upon either a signed lease from the borrower or may obtain a statement from the borrower of the gross monthly rent being charged (or to be charged) for the property. The monthly rental amounts must be stated separately for each unit in a two- to four-unit property. The disclosure from the borrower must be in the form of one of the following:

  • a written statement from the borrower, or

  • an addition to the Form 1003.

The lender must retain the documentation in the loan file that was relied upon to determine the amount of eligible rent reported.