House hacking is often one of the first strategies that many new real estate investors use because it’s a simple way to live for free while your renters cover your mortgage payments. House hacking involves buying a single-family or multifamily property and renting out the units or rooms you aren’t occupying.
If you are considering dipping your toes into real estate investing with this strategy, it’s important to consider the tax implications so you will know how much profit to report. Underreporting rental income on your taxes could cause problems for you later if you are audited.
Basics of Real Estate Taxation
Before you invest in your first rental property, it’s important to understand the basics of real estate taxation so you can set aside enough money to cover your annual taxes.
It’s also important to keep in mind that tax laws change every year. Don’t assume that just because something is tax-deductible one year that it will be tax-deductible the next. Always review current IRS regulations to make sure you have current information.
Also, consult with a tax professional when you are preparing your taxes. A tax professional will ensure your taxes are filled out correctly. Although you will have to pay a fee for the service, it will free your time for other things. It may also save you money by ensuring that you take all the legal deductions you qualify for.
Another important thing to remember with house hacking taxes is that you may be taxed at the local, state, and federal levels. Different localities and states have different tax laws, which is why you must contact your local and state tax authorities to determine your tax obligation.
At the local and state level, you will most likely have to deal with property taxes. There are also several taxes you will have to deal with at the federal level, including a tax on income, a capital gains tax when you sell, and a depreciation recapture tax.
Another thing to keep in mind with property taxes is that if a local tax authority overvalues your home, you can challenge the assessment. Assessments are estimations of your home’s current market value and aren’t always correct. You may be able to have the assessment corrected by presenting information about comparable homes in your community or other information.
Allocating Personal and Business Expenses
If you are house hacking, keep your personal and business expenses separate for tax purposes. Personal expenses, of course, are not tax-deductible. Keeping them separate can sometimes be confusing when you live in the same property that you are renting, however.
You must also determine the percentages of the property occupied by you and the tenant. This information will be used to determine the house hacking tax deductions you can take.
If you have multiple units, simply divide your unit by the total number of units to get a percentage. If you have a single-family home, you can either divide the room you occupy by the total number of rooms (bedrooms, bathrooms, kitchen, living room, dining room, etc.), or the square footage you occupy by the total square footage. This will give you the percentage of the home you occupy and the percentage of the home you rent.
Any costs that involve the space you occupy (such as replacing a window in your personal room) are not tax-deductible. Any costs that involve the rented portion or common areas of your properties are either fully or partially tax-deductible, based on the percentages you previously determined.
Let’s consider an example of allocating personal and business expenses on a house hack. Let’s say that your annual insurance premium on a property is $2,000, and you occupy 30% of the property. Therefore, 30% of the insurance premium ($600) is personal, while the remaining 70% ($1,400) is business-related.
Capital Gains and Sale of House-Hacked Property
If you sell a rental property, you will have to deal with capital gains and depreciation recapture taxes. When combined, the two taxes can be significant. It’s important to understand how they work before you sell to prevent any unpleasant surprises.
Capital gains is a tax on any profit you realize when you sell a rental property. For example, if you buy a rental property for $300,000 and sell it for $350,000, you will have to pay capital gains tax on the $50,000 profit.
Depreciation recapture is tax on previous depreciation deductions that lowered your taxable income. Although asset depreciation can save you a lot of money on your taxes short term, the IRS requires you to pay a special tax when you sell. It “recaptures” the depreciation deduction by taxing you on the difference between the sale price of the property and its depreciated value.
House Hacking and the Section 121 Exclusion
Section 121 of the U.S. federal tax code is a provision that allows some homeowners to exclude a portion of the capital gains on their homes when they sell. The Section 121 exclusion is sometimes referred to as the “home sales exclusion” or “capital gains exclusion.”
Unfortunately, if you are house hacking, you won’t be able to take full advantage of the Section 121 exclusion. Like many house hack tax deductions, you may only be able to apply a portion of the Section 121 exclusion to the part of the home that you occupy. The remainder of the home—the part that you are renting—is excluded.
Let’s say, for example, that you live in 10% of a property for three years, and you rent the other 90% out. You decide to sell at the end of year three because your property has appreciated, and you’ll net $150,000 after selling costs. That means 10% of the property will qualify for the Section 121 exclusion, while the remaining 90% will not.
Tax Deductions for House Hackers
It’s important to know what things are tax-deductible if you are house hacking to help you determine what records you need to keep. The following are some common house hacking tax deductions that you may be able to take:
- Mortgage interest: A portion of the mortgage interest in a house hack may be tax-deductible, based on the percentage of the home that you rent.
- Property taxes: A portion of your annual property taxes may be tax-deductible, based on the percentage of the home that you rent.
- Depreciation: Depreciation is an accounting strategy where you deduct a portion of the value of a property each year on your taxes. It’s important to keep in mind that rental property depreciation is only a reflection of a property’s book value and not its actual market value. You may be able to deduct a portion of a property’s annual depreciation, based on the percentage of the home that you rent.
- Repairs: Whether a repair is tax-deductible depends on where the repair is made in the home. You can’t deduct repairs made to the portion of the property you occupy, for example. For common areas, you can deduct an amount based on the percentage of the home you occupy. Repairs made to the rented areas may be fully deductible.
- Furnishings: Home furnishings—such as furniture, appliances, window treatments, home electronics, and decorative items—can be partially deducted, based on the percentage of the home that you rent.
- Utilities: You may deduct a portion of your utilities—such as electricity, water, and gas—based on the percentage of the home that you rent.
- Insurance premium: A portion of the insurance for your property may be tax-deductible, based on the percentage of the home that you rent.
- Advertising: There are many different ways that you can advertise your rentals, including online listings, local publications, signage, and social media. The expense associated with advertising rooms or units that are for rent may be tax-deductible.
- HOA fees: If your property is part of a homeowners association (HOA), you will be assessed a monthly HOA fee for property maintenance, amenities, security, and other things. You may be able to deduct a portion of the monthly fee on your taxes, depending on the percentage of the home that you rent.
Income Reporting
The income and expenses from a house hack are typically reported on an IRS Schedule E form, which is a form for supplemental income and loss for your individual tax return (Form 1040). Any depreciation you take on the property is also reported on this form.
As mentioned, it’s vitally important to separate your personal use of the property from the part that is rented when filling out your taxes. Typically, you can only deduct a percentage of an expense that is based on the part of the property that is rented. In some cases, you may be able to deduct 100% of an expense if it applies to a part of the home that is rented.
The Importance of Accurate Recordkeeping
Keeping accurate financial records is vital when you have any type of rental property so you can determine your taxable income. It will also protect you if you are ever audited.
Document every repair and improvement that you make to your property. Be sure to keep a detailed record of the purpose and the materials used for every repair. Also, keep all receipts, since they serve as proof that the repairs were made.
You should also keep track of your mileage when it involves property maintenance. The mileage deduction can be significant if you have to make frequent repairs.
The records you will need to keep when house hacking include:
- Income: Rent receipts, security deposits, and any other income that you receive from tenants.
- Expenses: Receipts for all repairs, insurance premiums, property taxes, mortgage interest, and other expenses.
- Asset purchases: Receipts for furniture, appliances, HVAC systems, flooring, security systems, window treatments, light fixtures, ceiling fans, etc.
- Depreciation: Maintain a schedule that shows how much depreciation you will be taking on your taxes each year. A tax professional may help you prepare this.
Preparing Your Taxes
When preparing your taxes, you have three options.
You can prepare your taxes yourself, use tax preparation software, or use a tax professional. Although it doesn’t cost anything to prepare your taxes yourself, it will take up a lot of your valuable time, and there may be errors. You may also miss some legal tax deductions that you can take.
Using tax software to prepare your taxes is a good option if your taxes aren’t too complicated. Hiring a tax professional, however, is usually the best approach. Because the tax code is complicated, a tax professional can save you time, ensure your taxes are filled out correctly, and ensure that you take every legal tax deduction that you are entitled to.
Final Thoughts
Keeping up with the continually changing real estate tax laws can be challenging. It’s also something that you don’t want to get wrong. Incorrectly reporting your income or taking deductions you aren’t entitled to could result in an audit and a hefty fine. In addition to paying federal taxes on your house hacking income, you also have to pay local and state taxes, which further complicates things.
If you are unsure of whether you can deduct a property-related expense or how much you can deduct, consult with a tax professional for clarification. The fee for their expertise is a small price to pay when compared to the headache of dealing with an audit.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
