One of the most difficult type of income to determine for managers of affordable housing rental properties (e.g. Section 8 or Low-Income Housing Tax Credit [LIHTC]) is self-employment income. Based on the number of issues we see when reviewing the tenant files of clients and the questions I receive on the subject during training, a discussion of best practices with regard to verifying and projecting income from self-employment is in order.
All affordable housing programs require that income from businesses be counted as part of household income, and virtually all such programs follow guidance of the Department of Housing & Urban Development (HUD) in how to deal with self-employment income. This includes the LIHTC program, for which the IRS has provided additional guidance relative to self-employed individuals.
Income from a Business
The net income from the operation of a business, profession, or sole proprietorship businesses is included in income. Net income is gross income less business expenses, interest on loans, and depreciation computed on a straight-line basis. Salaries paid to the applicant or other household members from the business must also be identified and included in income. In addition, cash and assets withdrawn by family members must be included in income except when the withdrawal is a reimbursement of cash or assets invested in the business.
Business expenses do not include principal payments on loans, interest on loans for business expansion or capital improvements, or other expenses for business expansion or outlays for capital improvements.
If the net income from a business is negative, it must be counted as zero income. A negative amount cannot be used to offset other family income.
Example: Negative Income from a Sole Proprietorship
- John and Mary, a married couple, apply for LIHTC housing.
- John operates a sole proprietorship business. The net income from the business after expenses in 2017 was -$3,500.
- Mary earns $27,000 annually as an employee, as verified by management with her employer.
- The household’s income is $27,000; the $3,500 loss by John’s business cannot be used to offset Mary’s wages.
Income from a business can be estimated by reviewing the individual’s prior year tax returns and Schedule C. If necessary, the owner can ask the potential resident to provide a signed Form 8821, Tax Information Authorization, or Form 4506-T, Request for Transcript of Tax Returns, which will allow the owner to verify the information with the IRS. Another option is to request that a copy of the transcripts be sent directly to the potential resident from the IRS by using the automated phone system (1-800-908-9946). While the transcript will be sent to the applicant and they will have to bring it to the manager, this process is faster and the applicant will normally receive the transcript(s) within ten days. It should be noted that a tax return must be filed for all self-employed individuals who operate sole proprietorship businesses or otherwise report income on Schedule C, regardless of whether the taxpayer is reporting a profit or loss. If a person is not eligible to get a Social Security Number, which is needed to file a tax return, an individual taxpayer identification number (ITIN) can be obtained using IRS Form W-7.
Income Projection Methods
There are a number of acceptable methods for projecting income from self-employment; three examples follow:
Example 1: A potential LIHTC tenant has been self-employed for four years and provides a self-employment affidavit (which is always recommended) stating that the anticipated net income for the upcoming year is $22,000. Tax return for 2014, 2015, and 2016 are obtained and show the following net income:
- 2014: $13,000
- 2015: $18,000
- 2016: $20,000
Based on the trend as shown on the tax returns, the estimated amount on the self-employment affidavit appears reasonable and may be used. However, if the 2016 return showed net income of $26,000, the applicant should be required to provide a credible reason for the anticipated reduction in income, and if they could not, the income should either be trended based on the percentage increase from year-to-year or the 2016 income should be used – depending on the circumstances.
Example 2: A potential LIHTC tenant has been self-employed for just over one year and provides a self-employment affidavit stating that the anticipated net income for the upcoming year is $22,000. The 2016 tax return is obtained and shows that $22,000 was the net income in 2016. It is reasonable to project $22,000 as the income from the business.
Example 3: The potential tenant has only been self-employed for nine months and no tax return has yet been filed. Income may be annualized based on the number of full months in business. The formula is:
(Net Income Year to Date) x 12 Months
Number of Months in Business during the Current Year
So, if for the nine months of the year in business the applicant had earned net income of $24,000, the formula is:
$24,000 X 12 = $288,000 ÷ 9 months + $32,000 anticipated net income.
A low-income tenant may use a portion of a low-income unit exclusively and on a regular basis as a principle place of business, and claim the associated expenses as tax deductions, as long as the unit is the tenant’s primary residence. If the tenant is providing daycare services, the tenant must have applied for (and not have been rejected), be granted (and still have in effect), or be exempt from having a license, certification, registration, or approval as a daycare facility or home under state law. IRS Form 8829, Expenses for Business Use of Your Home, and Publication 587, Business Use of Your Home, provide additional guidance on acceptable deduction from business income for home businesses.
Example: A self-employed bookkeeper wants to rent a two bedroom unit and intends to use one bedroom as her principle place of business; i.e., to provide bookkeeping services. She provides her tax return for the last year, which includes a Schedule C, as a verification of her income. The Schedule C includes an “office expense” for her home office in a prior residence. Use of a unit in this way meets the requirements of the LIHTC program, but it should be noted that Section 8 residents would not be able to use the second bedroom as a dedicated office.
Income from Rental Property, Partnerships, and S-Corporations
Rental property may be real estate or personal property such as equipment or vehicles. The tenant may have income from enterprises doing business as partnerships or S-Corporations, or receive royalties for copyrights or patents.
The key, when determining income for self-employed individuals, is to obtain enough information to reasonably project likely income for a 12-month period. As noted, tax returns are the preferred method of verifying such income, but financial statements (audited or unaudited) are acceptable when tax returns are not available. Also, it is strongly recommended that self-employed individuals always provide “Affidavits of Self-Employment” on which they state their anticipated income for the upcoming year.