A popular asset to own as part of your retirement plan is real estate. With all the “fix it and flip it shows” that have been around for years, this pushes more and more people to try out real estate as an income source. Heck when I watch Chip and JoAnna tear up a house in Waco Texas and make it spectacular, I think “hey I can do that”. But then I remember I don’t have construction skills… carpentry skills… design skills…. and move back in my lane of mortgage operations training!
I am sure many of us have seen borrowers with rental properties on the schedule E, but what if the borrower says he owns properties and hands you a business return such as IRS Tax Form 1065/ 1120S / 1120 that has an attached 8825?
Let’s start with the basics. The easiest way to explain the 8825 is that it is the “company” version of a schedule E rental real estate. The form looks very similar to the real estate schedule E and does the same function. So the same rules apply to looking at that form as it would personally owned real estate with a few twists which we will review next.
Next is let’s review the 8825 from an underwriting standpoint. The good news is that with one agency there is “no work” extra to complete (Freddie Mac) but with the other investor (Fannie Mae) we have to complete a rental income evaluation using a different form.
Lets start with Freddie Mac since the rules are the easiest. FHLMC states in their guidelines that they are not concerned about homes owned by a business but personally financed by the borrower. Pretty simple and black and white, don’t do any more work on this agency. What you need to do in your LOS is “wash” the payment out, then evaluate the business return of the company that owns the REO and follows standard self-employed requirements. Here is the guideline reference (from their new and improved guideline site!) https://guide.freddiemac.com/app/guide/content/a_id/1000660
Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S CorporationRefer to Chapter 5304 for the treatment of all rental real estate income or loss reported on the IRS Form 8825, which reflects all income and expenses for the rental property and the IRS Schedule K-1, which reflects the Borrower’s proportionate share of the net rental income or loss. The requirements of Chapter 5304 are applicable regardless of the Borrower’s percentage of ownership interest in the partnership or S corporation and regardless of whether the Borrower is personally obligated on the Note.
Next up Fannie Mae
Fannie takes a much different approach on personally financing a property. In their view you will ultimately be responsible for the payment and the special rental income calculation form 1039 shows this. Here is how the process works:
Step 1 – Ask the question “Is the borrower personally financing the property?” This can be determined by a credit report, VOM, or a copy of the note. Even if you don’t see the mortgage on the borrowers credit it is a best practice to ask for a copy of the note to confirm the borrower has not signed as a guarantor for the business.
Step 2 – If the property is not personally financed or guaranteed by the borrower stop here. Just like FHLMC you would stop here and just evaluate the business income following standard self employment rules for the business type
Step 3 – If the borrower is personally financing or guaranteeing the loan on the property the 1039 rental income evaluation form is required.
What is different on the 1039 rental income form versus the 1038 form?
The rental calculations we all know, and trust are found on form 1038, the big difference on the 1038 versus the 1039 is as follows
A – If the next result is an income
The best you can do is “wash” the payment from the debt load of the borrower. For example if the PITI was $1,000 and the borrower showed a $200 profit, you would adjust your LOS to simple make the $1,000 debt so that it did not add to DTI or add to income.
B – If the net result is a loss
The borrower must have all the debt added to his/her DTI regardless of the percentage of ownership of the business. For example, if the 1039 showed a loss of $300 per month and the borrower was 50% owner of the business, the borrower would have to have $300 per month added to their debt load. Some people might think only 50% of the loss ($150) since the borrower is only 50% owner but that is not true.
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