Christopher Almost Lost His House Over a Rental Loss on His Tax Return
Christopher almost lost the house he was under contract on, because a rental property looked like a loss on his tax return.
Christopher is a fictional, illustrative buyer near Isle of Palms, SC. He is not a real client, but his situation is a common one: a buyer already owns a rental, has reported rental income on tax returns for years, and now wants to buy a home with an FHA loan.
How a rental becomes a loss on paper
Rental activity is reported on Schedule E. The bottom line of that form can show a loss because the form carries items such as depreciation, mortgage interest, taxes, insurance, and HOA dues. Those items reduce the net number even though they are different kinds of costs.
If a lender looks only at that bottom line for a single year, Christopher's rental looks like a liability. That is how a deal under contract can start to wobble. The buyer did nothing wrong. The file was simply read the wrong way.
What the FHA guideline says
Here is the FHA guideline word for word:
Where the Borrower has a history of Rental Income, the Mortgagee must obtain the Borrower's last two years' Tax Returns with Schedule E. The Mortgagee must calculate the net Rental Income by averaging the amount shown on the Schedule E. Depreciation, mortgage interest, taxes, insurance, and any HOA dues shown on Schedule E may be added back to the net income or loss.
There are three parts to that passage, and each one matters.
First, the lender must obtain your last two years of tax returns with Schedule E. The rule starts with a history of rental income, which is exactly what Christopher has.
Second, the lender must calculate net rental income by averaging the amount shown on the Schedule E. That is an averaging requirement, not a read-the-last-line requirement.
Third, depreciation, mortgage interest, taxes, insurance, and any HOA dues shown on Schedule E may be added back to the net income or loss. The guideline says the figure can be a loss, and it names the items that may be added back.
Why averaging and add-backs matter
When you average the Schedule E amounts, you are looking at the rental across the returns the guideline calls for, not one year in isolation. When you apply the add-backs, you are adjusting the net figure for the items the guideline lists. Together, those two steps can change how the rental is treated in the file.
I cannot tell you what any particular borrower's number will be. That depends on the actual returns, the property, and the rest of the borrower's finances. What I can tell you is that the calculation has a defined method, and you are entitled to ask whether it was followed.
The question Christopher should ask
Here is the tactical part. Request your last two years of federal tax returns with every Schedule E attached. Then ask your lender this:
"Are you calculating my net rental income by averaging the Schedule E, and are you adding back depreciation, mortgage interest, taxes, insurance, and any HOA dues, under the FHA guideline?"
A clear answer tells you the file is being handled the way the guideline describes. A vague answer tells you to keep asking before the file goes further.
What to do today
Pull your two most recent federal returns and confirm that every Schedule E page is included. Note which add-back items appear on each one. Bring them to the conversation with your lender so the review starts with complete paper instead of assumptions.
If you own a rental and want to buy a home with an FHA loan, my job is to find the path. I will walk through your returns with you and explain what the guideline asks for.
A note on taxes
This article is general information, not tax advice. Depreciation and other tax items are reported differently for every owner, so talk to a CPA or tax professional about your own returns.
Call me, Jason Sharon, at 843-LOW-RATE.
Home Loans Inc - Jason Sharon, Mortgage Broker. Company NMLS #1728740, Jason Sharon NMLS #1281448. Equal Housing Opportunity.
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