Schedule E Rental - Matching Debt to Ownership Percentage
Introduction
An analyst recently called in to the Bukers Hotline with a fantastic question about the breakout of debt for rental property. The analyst explained that the bank issues debt to a rental property that is owned by two separate individuals. In their cash flow analysis, the bank requests tax return information from both individuals to evaluate their ability to service the rental debt. The analyst’s question: should the bank apply the entire amount of rental debt to each individual owner’s analysis?
Answering the Analyst
Let’s begin by directly answering our analyst’s question. The bank should not apply the entire amount of debt related to the shared rental property to each separate owner. Instead, each individual owner should receive a portion of debt that best represents their ownership interest in the rental property. The most convenient way to determine each of their separate debt interests would be to look at the way income is split between them on their respective Schedules E.
Let’s assume in this case, one owner received 80% of the profits and the other received the remaining 20% of the profits. In that instance, it would be reasonable to apply that same 80/20 ratio to the total rental debt. Whoever received 80% of the profits would also be credited with 80% of the rental debt, and vice versa. By splitting the debt in this manner, the analyst avoids double counting and ensures the rental debt-to-income ratio is accurately reflected for each owner.
Why Can't We Apply the Full Debt to Each Owner?
When we are analyzing business entities with multiple owners (sometimes called shareholders or partners), in most situations we typically recommend applying the debt pro rata to each co-owner according to their ownership. This helps us avoid double counting. If instead we decided to simply give the full amount of debt to each separate owner, we would then be comparing 100% of the rental income to 200% of the rental debt. Without representing things properly with respect to the true economic impact, we risk having misstated ratios and making the wrong lending decisions.
Important Caveats
The information provided above reflects our general guidance for the average borrower’s return. However, it is important to note that there are exceptions to this guidance for more specified situations. Depending on how the ownership of the property is structured and how the mortgage on the property is set up (whether both co-owners sign the mortgage or just one does) it is possible that only one owner could be solely liable for the entire debt. Also, if a partnership entity (or joint venture) owned the property, the underlying agreement could state that one partner be allocated all liabilities of the partnership in case of default. In this instance, we would allocate all rental debt to that partner, so that our analysis follows suit with the underlying partnership agreement.
These additional agreements and stipulations are the ultimate authority when it comes to the breakdown of debt sharing. At the end of the day, we want our analysis to match the borrower’s actual situation as closely as possible. This is why, as a lender, it is so important to get as much information about the borrower as possible. The more we know, the more accurate we can be as we apply our cash flow analysis to their given situation.
Key Takeaway For Lenders
In most cases, rental property debt should be allocated to each owner based on their ownership interest to avoid double counting. However, analysts should always review loan documents and ownership agreements for provisions that may assign liability differently.
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This was a great question and one that helped make the difference in this borrowing situation. All users of the Bukers software or Bukers Academy have access to our Bukers Hotline, where we help with these kinds of situations every day. Our experts are trained to handle any questions related to cash flow analysis and can provide helpful guidance for Bukers customers. Our team of CPAs is standing by and ready for your call at 503-520-1303!