The tenant screening process is multifaceted. It takes a significant amount of time and effort.
However, it’s essential to ensure that the next tenant to occupy your property will respect it and can pay rent consistently. To judge whether a tenant will be able to pay rent, landlords and property managers need to have a clear understanding of the tenant’s finances.
The best way to gain this understanding is through income verification. Landlords accomplish that by requiring prospective tenants to submit proof of income before signing a lease agreement.
That said, it can be difficult to know where to start. That’s where we come in.
Here’s everything you need to know about proof of income and how it can be a great tool for your rental business.
- What is Proof of Income?
- What Can Be Used as Proof of Income?
- How to Prove Income If a Tenant is Self-Employed
- How to Determine if a Tenant Meets Income Requirements: Rent-to-Income Ratio
- Final Thoughts
What is Proof of Income?
Proof of income is a way to verify that a prospective tenant has a steady source of income that would allow them to comfortably afford rent. The prospect supplies the landlord or property manager with documents that support the income listed on their application.
Income verification is a part of the tenant screening process. It helps property managers gain the full picture of their tenant’s financial situation.
If a tenant dishonestly claims to have a steady stream of income that will guarantee their ability to pay rent, landlords risk renting to someone they’ll eventually have to evict due to rent non-payment.
What Can Be Used as Proof of Income?
As there are many different forms of income, there are also many different ways to prove income. It’s important to know what to look for in a document that a tenant submits as proof of income. It’s also important to know how prospective tenants can obtain them.
Here are some of the most common forms of proof of income to be aware of and where to find them.
- Pay Stub – A paystub is given out to employees at the end of each pay period. It details their hourly rate or salary, how often they work, who employs them, and more. Pay stubs provide landlords with a lot of information about prospective tenants. Landlords can also use them to verify other details in the tenant screening process.
- Proof of Income Letter – A proof of income letter typically features a lot less information than a pay stub. However, an employer provides it. It details how much the employee makes.
- Wage and Tax Statement (W-2) – A W-2 statement is used for tax purposes. It provides information about a prospect’s annual earnings. If your tenant has multiple employers, you may ask to see a W-2 from each employer.
- Last Year’s Tax Return (1040) – Tax form 1040 details all the sources of income that a prospect has earned over the tax year. The drawback to utilizing this form as proof of income is that it only proves income from the previous year. You’ll have to verify that the tenant’s job status has not changed to get an accurate report.
- Bank Statements – Bank statements are typically used to verify income for self-employed tenants. That’s because they don’t have a traditional source of income. A bank statement only details the amount of money that is deposited in the account and the amount coming out. You can’t use it to verify job status.
- Pension Distribution Statement – If your tenant receives a pension that serves as their income, they can provide you with a pension distribution statement. A tenant may provide you with tax form 1099-R. That would show their yearly pension distribution income.
- Social Security Proof of Income Letter – Some prospective tenants may receive Social Security benefits as their source of income. They will be able to request a letter that details their monthly payments.
- Court-Ordered Agreements – If your tenant has any outstanding agreements that contribute to their monthly income such as alimony payments, settlement fees, or child support, it’s important to consider this income. The court will provide the prospect with a letter detailing the agreements.
- Workers’ Compensation Letter – Workers comp is distributed in cases where an employee is injured on the job. The payout may serve as part of or the total of their income. You can verify this via a letter from the court or an insurance company.
- Unemployment Compensation Letter – People who have been laid off from their jobs receive unemployment assistance. There are caps to unemployment benefits. However, they’re meant to serve as a living wage. The unemployment office in your county will supply unemployment compensation letters.
- Annuity Statement – An annuity statement details income that comes from an agreement that a prospect has with an insurance company. These statements show the exact amount of money the tenant earns. They also show the payout schedule. An insurance company sends them out.
- Interest and Dividend Income – If you’re renting to an investor, they may be paid out dividends and interest that accounts for some or all of their income. These may be reported on tax form 1040.
- Severance Statement – A prospect may have recently been laid off or have left their job. However, that doesn’t mean the tenant doesn’t have a steady income. Depending on the job, your tenant may have gotten a generous severance package. That can serve as their income. Their severance statement will show how much the company will pay them. The employer provides this document.
There are some cases in which you might choose to require a combination of documents to support proof of income. That especially applies to documents that support a temporary stream of income.
For example, a dividend statement in addition to last year’s tax return would provide an accurate picture of a prospect’s finances.
It’s also important to keep in mind that some tenants may forge an official document. Not only is this against the law, but it also puts you at risk of renting to a bad tenant.
You must do your due diligence to ensure that the documents are real and accurate. You may require additional documentation or request reference letters to support evidence of income.
How to Prove Income If a Tenant is Self-Employed
With the rise of the gig economy and self-employed workers becoming more common, you may find yourself considering a prospect without a traditional source of income.
Typically, this translates to a non-traditional proof of income. That can make things more difficult for you. However, you shouldn’t write off a self-employed tenant, especially if they can supply you with one or both of the following documents:
- Tax Form 1099 – This tax form is required for anyone who earns over $400 in self-employment income. It lists all the income an individual has earned in the past year. It also lists how much tax they pay on that income.
- Bank Statements – Some tenants may hesitate to provide their bank statements for review. However, that’s common for self-employed people. Bank statements prove that money is coming into an account on a monthly basis. You can ask for multiple statements dating back a few months to get an estimate of their regular monthly income if it fluctuates.
Regardless of the proof of income you require from your tenants, all documents should contain the following information:
- Income Amount
- Your Full Name
- The Tenant’s Full Name
- Employer Name (if applicable)
- Additional Identifying Information (Social Security number, birthdate, etc.)
How to Determine if a Tenant Meets Income Requirements: Rent-to-Income Ratio
Once your tenant provides you with their proof of income documents, what do you do with the information? How does it help you determine whether they can comfortably afford to rent your unit and won’t be considered rent-burdened?
Easy — you utilize the rent-to-income ratio.
Apartment List’s rent calculator is a useful tool that’ll help you calculate the amount a tenant is able to comfortably afford for monthly rent payments.
The industry standard suggests that the monthly rent payment should not exceed 30% of a tenant’s monthly income. Additionally, the total monthly household income should be 2-3x the monthly rent. However, depending on the market you’re renting in, it may be common for tenants to pay much more than that.
Some landlords prefer to utilize the “rent coverage ratio.” You can calculate this ratio by dividing your income by your total expenses.
A good rent coverage ratio is 1.3 or higher. For example, if a tenant’s monthly income is $3,000 and their expenses including rent are $2,000, then their rent coverage ratio would be 1.5. That would mean that they can comfortably afford rent.
As a landlord or property manager, finding high-quality tenants can save you a lot of time and money in the future. Great tenants set you up for long-term financial stability. That’s why it’s imperative to do your due diligence well and very early on.
Your tenant screening methods should include requiring a tenant to provide proof of income — sometimes with multiple documents! Regardless of the tenant screening methods you choose, it’s essential to comply with local and federal laws.