What Schedule E Income Covers
Schedule E captures supplemental income from several sources that flow to your personal tax return. The most common types are rental income from investment properties and royalty payments from intellectual property, mineral rights, or other assets.
Say you own a duplex that generates $2,400 monthly rent and you also receive $500 quarterly in oil royalties from inherited mineral rights. Both income streams appear on Schedule E and transfer to your Form 1040.
However, if you receive distributions from a partnership, S-corporation, estate, or trust, your lender should use the Schedule K-1 forms instead of Schedule E. The K-1 provides more detailed information about the nature and sustainability of these distributions.
How Lenders Verify Royalty Income
For royalty income, lenders need proof you've received payments for at least 12 months. They also must document that these payments will likely continue for at least three years after your loan closes.
Your lender will request copies of royalty agreements, lease contracts, or licensing deals that show the payment terms. For mineral royalties, they might need documentation from the oil or gas company showing production history and remaining reserves.
If you receive book royalties, the lender needs your publishing contract and sales history. Patent royalties require the licensing agreement and evidence the patent hasn't expired or been challenged.
Calculating Rental Income from Schedule E
Rental income calculations get complex because lenders must account for all operating expenses while avoiding double-counting mortgage payments. Your Schedule E shows gross rental income minus expenses like maintenance, advertising, management fees, utilities, HOA dues, and supplies.
The lender starts with your net rental income from Schedule E but then makes several adjustments. They add back depreciation since it's a non-cash expense. They also add back any one-time extraordinary expenses like storm damage repairs that won't recur.
Here's where it gets tricky with mortgage payments. If the rental property mortgage payment is already subtracted on Schedule E, but the lender also counts it as a monthly debt obligation in your debt-to-income ratio, they must add back the mortgage payment to avoid counting it twice.
Say your duplex generates $2,400 monthly rent with $800 in operating expenses and a $1,200 mortgage payment. Your Schedule E shows $400 net income ($2,400 - $800 - $1,200). But if the lender counts the $1,200 mortgage as a debt obligation, they'll add it back to get $1,600 in qualifying rental income ($400 + $1,200).
Required Documentation for Schedule E Income
Lenders need your complete tax returns for the past two years, including all schedules. For rental properties, they also require a current lease agreement for each property and a rent roll showing all units and current rents.
You'll need to provide the Schedule of Real Estate Owned from your loan application. The lender will only count rental income from properties listed on this schedule.
For royalty income, gather contracts, agreements, or leases that establish the payment terms. Include 12 months of bank statements or 1099 forms showing actual receipt of payments.
If you have property management companies, provide their statements showing gross rents collected and expenses paid. This helps verify the accuracy of your Schedule E reporting.
Why These Rules Exist
Fannie Mae requires extensive documentation for Schedule E income because these income sources can be volatile and difficult to predict. Rental income depends on occupancy rates, local market conditions, and property maintenance needs.
Royalty income can fluctuate based on commodity prices, production levels, or market demand for licensed products. A patent might face legal challenges, or an oil well might run dry.
The 12-month history requirement for royalties ensures the income stream is established, not just a one-time payment. The three-year continuation requirement protects against lending based on income that might disappear shortly after closing.
Common Problems with Schedule E Income
Passive loss limitations create the biggest headaches. If your rental properties show losses on Schedule E due to depreciation and other expenses, you might not be able to deduct those losses against other income if your adjusted gross income exceeds certain thresholds.
These passive loss carryovers accumulate on your tax returns and can complicate the lender's income calculations. The underwriter must determine whether the losses represent actual cash flow problems or just tax benefits from depreciation.
Another common issue arises when borrowers fail to list all rental properties on their loan application. If you own a rental property that doesn't appear on your Schedule of Real Estate Owned, the lender cannot count its income even if it shows positive cash flow.
Seasonal rental properties present verification challenges. A beach house that only generates income during summer months requires careful analysis to determine sustainable annual income.
When Schedule E Income Gets Complicated
If your rental income declined significantly from one year to the next, the lender might not count it at all. A 20% or greater decline raises questions about market conditions, property condition, or management issues.
Properties with negative cash flow create debt-to-income ratio problems. Even if you have other income to cover the shortfall, the negative rental income counts against your qualifying ratios.
Mixed-use properties where you live in part of the building require special calculations. The lender must separate your personal housing costs from the rental income portion.
Recent property acquisitions need careful documentation. If you bought a rental property within the past year, the lender needs the purchase contract, current lease, and evidence of rental market rates to project income.
References
For the official guidelines, see B3-3.3-05: Income or Loss Reported on IRS Form 1040, Schedule E in the Fannie Mae Selling Guide.
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Original Fannie Mae Guideline Text
B3-3.3-05, Income or Loss Reported on IRS Form 1040, Schedule E (09/30/2014)
Overview
Income received from rents, royalties, and distributions from partnerships, corporations, estates, trusts, etc., is calculated on IRS Form 1040, Schedule E, and transferred to IRS Form 1040.
Rather than using Schedule E for income related to distributions from partnerships, corporations, estates, and trusts, the lender should rely on Schedule K-1 (see B3-3.3-07, Income or Loss Reported on IRS Form 1065 or IRS Form 1120S, Schedule K-1).
Royalty Income
Schedule E should be used to determine the supplemental income to use for royalties. The lender must include the total amount of royalty payments received, and must document the borrower’s receipt of royalty income for 12 months and the likelihood of continued receipt of such income for at least three years (see B3-3.1-09, Other Sources of Income)
Rental Income
If rental income is reported on Schedule E, only the rental income that relates to properties shown on the Schedule of Real Estate Owned on the borrower’s loan application should be included.
All regular and ongoing expenses for the properties, such as maintenance, advertising, management fees, utilities, homeowners’ association dues, and supply costs, should be subtracted from the borrower’s cash flow.
Depending on the approach used to calculate cash flow, adjustments will need to be made for depreciation and any one-time extraordinary expenses, such as the costs of repairing damage that resulted from a natural disaster.
In most situations, the full amount of the mortgage payment for a rental property will be factored into the net rental income calculation, but it may also be counted as part of the liabilities that are considered in the calculation of the borrower’s total debt-to-income ratio. Therefore, the lender must add back any portion of the mortgage payment, including interest, taxes, and insurance, necessary to avoid double counting of these expenses.
The lender must pay particular attention to the effect of “passive loss” limitations or prior “carryovers” related to the borrower’s rental properties and, depending on the method it uses for the cash flow analysis, make any special adjustments necessary to account for them.
