Calculating Self-Employment Income: A Step-by-Step Guide

Introduction

Of all the income types we encounter in affordable housing, self-employment income causes the most confusion. Unlike W-2 wages with neat pay stubs and employer verifications, self-employment requires us to interpret tax returns, understand business expenses, and project future income.

Let's break it down step by step.

What Qualifies as Self-Employment Income?

Self-employment income includes any earnings from work where the individual is not an employee. Common examples:

• Gig economy work:: Uber, Lyft, DoorDash, Instacart drivers

• Freelance services:: Graphic designers, writers, consultants

• Small business owners:: Landscapers, house cleaners, childcare providers

• Contract workers:: 1099 employees, independent contractors

• Cash-based businesses:: Hair braiders, handymen, food vendors

Key Indicator: If they receive a 1099 instead of a W-2, or if they have no tax documentation but report earning money from their own business or services, it's self-employment.

The Two-Year Look-Back Rule

For most affordable housing programs, we use a two-year average of net self-employment income. Here's why:

• Self-employment income fluctuates year to year

• A two-year average smooths out unusually good or bad years

• It provides a more accurate picture of expected ongoing income

Important Exception: If the business is less than two years old, use whatever history is available. If brand new (less than one year), you may need to project income based on current earnings and business documentation.

Step-by-Step Calculation Process

Step 1: Obtain the Tax Returns

Request the two most recent years of complete federal tax returns, including:

• Form 1040 (individual return)

• Schedule C (Profit or Loss from Business) — most common

• Schedule E (Rental income, partnerships, S-corps)

• Schedule F (Farm income)

• Form 1065/Schedule K-1 (Partnership income)

What if they didn't file taxes?

This is a red flag but not a disqualifier. You'll need to:

• Document why they didn't file (income below threshold, etc.)

• Obtain alternative documentation of income and expenses

• Consider requiring a certified accountant statement

Step 2: Locate the Net Profit/Loss

The figure you need is net profit (or loss) — gross income minus business expenses.

Where to find it:

• Schedule C:: Line 31 (Net profit or loss)

• Schedule E:: Line 26 (Total rental real estate income/loss)

• Schedule F:: Line 34 (Net farm profit or loss)

• Schedule K-1:: Box 1 (Ordinary business income)

Step 3: Add Back Depreciation

This is where many staff make errors. Depreciation is a non-cash expense — the business owner didn't actually spend this money; it's a tax deduction for the "wear and tear" on business assets.

For affordable housing income calculations, we ADD depreciation back to net income.

Where to find depreciation:

• Schedule C: Line 13 (Depreciation)

• Schedule E: Line 18 (Depreciation expense)

• Form 4562 may provide additional detail

Formula:

Net Self-Employment Income = Net Profit (Line 31) + Depreciation (Line 13)

Step 4: Calculate the Two-Year Average

Once you have the adjusted net income for each year:

Year 1 Adjusted Net Income + Year 2 Adjusted Net Income ÷ 2 = Annual Self-Employment Income

Example:

• 2024 Net Profit: $18,000 + Depreciation $2,000 = $20,000

• 2025 Net Profit: $22,000 + Depreciation $2,500 = $24,500

• Two-Year Average: ($20,000 + $24,500) ÷ 2 = $22,250 annual income

Step 5: Consider Business Trends

The two-year average is your baseline, but you should also evaluate:

Is the business growing or declining?

• If Year 2 is significantly higher than Year 1, the business may be growing

• If Year 2 is much lower, investigate why — is the business failing, or was Year 1 unusually high?

Are there changes that affect future income?

• Did they lose a major client?

• Did they expand their business?

• Are they planning to reduce hours?

Document your analysis. If you deviate from the straight two-year average, explain why in the file.

Handling Losses

What if the tax return shows a net loss?

You cannot count negative income. If the self-employment shows a loss:

• Count the self-employment income as $0

• Do NOT subtract the loss from other household income

• Document that the business operated at a loss

But wait — how do they survive?

Good question! If someone shows a business loss but is clearly paying rent and living expenses, investigate:

• Do they have other income sources?

• Are they drawing from savings?

• Is a household member supporting them?

• Are they underreporting income?

Special Situations

Gig Workers with Multiple Platforms

A driver who does Uber, Lyft, AND DoorDash may receive multiple 1099s. Ensure you're capturing ALL self-employment income, not just the most obvious one.

Cash Businesses with No Tax Returns

For individuals who work for cash and don't file taxes:

1. Obtain a self-certification of income

2. Request any available documentation (invoices, receipts, bank statements)

3. Consider having them complete a detailed income log for 30-60 days

4. Document everything — your file note should explain how you determined income

Seasonal Self-Employment

Some self-employment is seasonal (landscapers, tax preparers). Use the full-year figures from tax returns — they already account for the off-season.

Common Mistakes to Avoid

• ❌ Using gross income instead of net profit

Gross income is before expenses — always use the net figure (plus depreciation).

• ❌ Forgetting to add back depreciation

This is money they didn't actually spend. Add it back.

• ❌ Using only one year of returns

Unless the business is new, you need two years.

• ❌ Ignoring losses

A loss means $0 income from that source — but investigate how they're paying bills.

• ❌ Not asking about self-employment

Many people don't think their "side hustle" counts as income. Ask specifically: "Do you earn any money from work where you're not an employee?"

Your Self-Employment Checklist

• ✅ Obtain two years of federal tax returns with all schedules

• ✅ Locate net profit on Schedule C (Line 31) or equivalent

• ✅ Find and add back depreciation

• ✅ Calculate the two-year average

• ✅ Evaluate business trends and document your analysis

• ✅ If loss, count as $0 and investigate living expenses

• ✅ Complete your calculation worksheet and file it

The Bottom Line

Self-employment income requires more analysis than W-2 wages, but it's manageable with a systematic approach. The key is understanding that we're looking for net profit plus depreciation, averaged over two years — and always documenting our reasoning.

• Have a tricky self-employment situation? Total Compliance Consulting provides income calculation reviews and staff training for properties with Section 8, LIHTC, HOME, and Rural Development programs. [Contact us](/contact) with your questions.