One of the most commonly mentioned benefits of real estate investing is the tax benefits you receive, but what about house hacking taxes? The good news is that house hacking actually offers a large array of great tax benefits!
In this guide, you’ll learn everything you need to know about how house hacking impacts your taxes and the many tax benefits it can provide.
If you need a refresher on what house hacking is, be sure to check out our complete guide to house hacking.
Receiving Tax Benefits from Your Primary Residence
When one begins to research personal finance and try to take control of their money, they generally look at two areas — income and expenses. Generally speaking, there are two ways to increase how much money you’re able to save, or enjoy, and those are to increase your income or decrease your expenses.
When it comes to expenses, people often look at how much they’re spending on food, going out, shopping, etc., but what is often missed and not considered is how much they’re paying in taxes.
If you are house hacking you may have multiple options for reducing taxes that would not be available to you if you lived in your primary residence but did not house hack.
While we’re going to dive into options that you have, the important legally necessary disclaimer:
The preceding, and following, content is for informational purposes only. You should not construe any such information or other material as legal, tax, investment, financial, or other advice.
With that out of the way, let’s dive in!
You’re Psychologically Programmed to Not Think About Taxes
This is a psychological phenomenon that occurs because people typically do not see the amount of money they’re paying in taxes, as they do when they buy groceries or go out to dinner.
Of course, that information is readily available to them on their paystubs from their employer if they ever want to see it, but in today’s age with direct deposit, not many people look at it. It is like that old saying, “out of sight, out of mind.”
Because of this phenomenon, many financial professionals and educators highly recommend automating your savings and investing.
If it happens automatically, hedonic adaptation causes the amount you receive each pay period, net of savings and investing, to become normal, and you learn to live off that amount. It works the same way with taxes despite being the largest expense for many people.
The money just slips out the door without you paying much attention to it.
House Hacking Reduces Your Tax Bill, Traditional Homeownership Doesn’t
One of the major benefits is that it can help reduce your annual tax bill. It likely is not going to reduce the amount taken automatically from your paycheck each pay period, but it can have an impact on how much you’re required to pay in taxes at year-end, which can still be a substantial saving.
When you purchase a property as a traditional homeowner, you have very few tax deductible items or creative tax options.
However, when you purchase a house hack, that now becomes a business, which opens up the world of tax options for you.
As a house hacker, you are able to:
- Deduct expenses related to running your rental units
- Take advantage of depreciation
- Utilize the two-of-the-last-five-years rule or 1031 exchange
If you don’t know what those phrases mean, don’t worry. You do not need to be a tax expert to be a successful house hacker, and we’ll go over what they mean in the sections below.
Still, at least understanding the fantastic tax benefits it can provide, even from a high level, adds another exceptional benefit to this strategy.
Understanding House Hacking Taxes
The US Tax Code is Complex and Dense
The tax code in the United States is extremely complex and dense. There are hundreds of thousands of individuals who dedicate their entire careers to studying this material, as well as hundreds of large firms that provide tax-related services.
There are entire, multi-hundred-page books written about various tax topics, and everyone’s situation is different. Our website and blog posts are also not allowed to legally give tax advice.
For those reasons, this blog post will cover the most important, general tax items related to house hacking taxes, but you are encouraged to get more detailed and individual-specific advice from a qualified tax professional.
To summarize the extremely complex and dense United States tax code simply, based on one’s income and life characteristics, they are required to pay a certain amount each year to the Internal Revenue Service, known as their annual tax bill.
Typically, this is paid in installments throughout the year via a paycheck. At the end of the year, if the person paid more in taxes throughout the year than their total tax bill amount, the difference is returned to them in the form of a tax refund.
There can be many nuances here and different tax credits and initiatives impact one’s annual tax bill, but in a very simplified manner, this is how an individual’s taxes work.
Top Tax Write-Offs For Owner-Occupied Rental Property
A tax write-off is an expense you paid that you are allowed to deduct from your income or tax bill on your tax filings to lower your tax expense. In theory, the more tax deductions you have, the more your annual tax bill is reduced, and therefore, the less you have to pay, or the more you get in the form of a refund.
When you are a traditional homeowner, there are typically very few expenses related to your home that you are able to write off. However, when you house hack, the amount of expenses you are able to write off increases significantly.
When you are house hacking, your rental units are technically considered a business, even without having a registered legal entity. This is typically done through a Schedule E in your tax return.
There is a common misconception in the real estate industry, especially for newer investors, that an LLC is required to start investing in real estate. Having an LLC to invest may be the right option for you, but it is not necessarily required. Talk with your tax professional and an attorney to determine what is right, and necessary, for you.
Since your rental units are considered a business, you are allowed to deduct expenses related to that business activity. The deductions have to be proportional to the amount of the property utilized for a rental. Let’s look at an example of a house hacking duplex to show what items may be tax deductible and how the proportionality works.
The two units in a duplex do not have to be the same size or layout, but they are often quite similar, if not identical, just because of how it is built. Therefore, let’s assume you have a townhouse-style duplex with left and right units. The total square footage of livable space in the building is 2,400, which is split evenly between the two units — 1,200 in each unit.
This breakdown of livable square footage allocation is important when deducting your expenses proportionally. Generally speaking, since fifty percent of the square footage of this building is utilized as a rental property, you can write off fifty percent of tax-deductible expenses.
Tax-deductible expenses can encompass many different things. One of the most common examples is landscaping and/or landscaping equipment. If you live in an area of the world where it snows, half of your cost for snow removal should be tax-deductible, since half of it is for your rental unit.
Similarly, if you hire a landscaping company rather than doing it yourself, you should also be able to deduct half of that cost. If you choose to do your landscaping yourself, you may be able to deduct half of your cost of purchasing a lawn mower, snowblower, weed whacker, or other similar equipment that is required to maintain the property.
This same approach can be extrapolated across many things relating to the property. If it is required for the property or rental unit and considered necessary and ordinary, it is possible that it is tax deductible.
While being able to write off fifty percent of an expense is a great benefit of house hacking, it can get even better. Instead of a duplex, imagine you house hack a fourplex and lived in one of the units. Now, you may be able to deduct seventy-five percent of the expense.
Depending on the square footage of the unit you’re living in, if it’s much smaller than the other units, you may be able to deduct even more!
Depreciation
Another major tax benefit is that you are able to utilize depreciation. Depreciation is a non-cash accounting expense that you can often deduct from your rental income. The Internal Revenue Service allows investors to write off depreciation as a way to account for the wear and tear a property receives.
The logic behind this tax code is that a property can only be used for so many years before it needs to be renovated or becomes uninhabitable. The Internal Revenue Service has determined how long a property is supposed to remain in habitable condition, so they let you write off a portion of the property’s value each year over that period of time.
As of this writing, real estate investors are required, by the Internal Revenue Service, to use a useful life of twenty-seven and a half years when calculating depreciation on a residential rental property, such as a house hack.
The non-cash portion of the depreciation definition is important because it means that you are not outlaying or losing any of the cash in your pocket. Rather, it is an accounting number that shows on your financial statements.
You are able to reduce your income, and therefore your annual tax bill, without actually having to spend any money. Be sure to connect with a qualified, real estate-specific tax professional to discuss the specifics of your situation, what you can deduct, and how depreciation may work with your property.
Two-Out-of-Five Rule
The two-out-of-five-year rule is a bit more common and simple to understand than the 1031 Exchange that you will learn about next. According to the Internal Revenue Service, the two-out-of-five-year rule says that if you have lived in a property for a minimum of two years in the past five years prior to the sale of the property, you are able to exclude up to $250,000 of your gains for individuals, and up to $500,000 for a joint return.
The great news is that you do not have to live the at the time of the sale, you just have to have lived there for two of the last five years.
A great way to utilize this strategy could be to buy a house hack and live there for two years while you save up the down payment for your next house hack. Then, once you have enough money, buy your second house hack and move there, keep the first house hack as a traditional rental, and then sell it in under three years from the date you move out.
If you set this up properly, you could build a ladder of these by doing this for one house hack, then another, then another, and so on.
1031 Exchange
A 1031 Exchange, which gets its name from being part of Section 1031 in the United States Internal Revenue Code, allows you to defer paying the amount owed on your capital gains from the sale of an investment property if those funds are reinvested into an asset of like-kind within the specified time frame.
For example, you may be able to utilize a 1031 Exchange to defer the capital gains taxes you owe on an investment property, say a duplex, that you bought for $100,000 that is now worth $500,000, if you use the proceeds from the sale of the property to buy another investment property that is similar to the one you just sold.
1031 Exchanges are very complex and there are a lot of specific rules that need to be followed in order to do it properly and legally. The important takeaway is to understand that this may be an option for you because you chose to house hack, and it should be noted as something to discuss with your tax professional and/or a 1031 Exchange Advisor.
It can be very easy to fall down a black hole of tax strategy and all the intricacies. Rather than spending your time becoming an expert on it, understand it from a high level and hire out the specifics to a professional.
This professional will not only handle the specific tax code items that are applicable to your situation, but they should guide you on what you need to track for information throughout the year.
It is important to note that a tax professional is not necessarily your bookkeeper. If you choose to outsource your bookkeeping to an accounting or bookkeeping firm, then a tax professional could also be your bookkeeper, but if you have decided to do it yourself or utilize a virtual assistant, the tax professional is separate.
You or your virtual assistant will handle your day-to-day accounting and bookkeeping, then your tax professional will take that information and complete your tax filings for you. While the two are separate and different, they are also related.
It’s very important that you have clean financial records, meaning that your income and expenses are recorded timely and correctly. This not only provides you with a clear picture of how your property is operating, but it also makes your tax professional/CPA’s job much easier (which saves you money!). I personally love using the free real estate-specific accounting software from Stessa for all of my house hacking and rental property bookkeeping — and my CPA loves the clean financial statements, too!
Frequently Asked Questions About House Hacking Taxes
What can you write off on a rental property is covered in detail in this post, but in general, you can write off expenses related to your rental unit, and also utilize depreciation.
When it comes to house hacking taxes, there are a number of benefits the strategy provides. In terms of how taxes work on a house hack, you claim your rental income and write off your related expenses on your tax return, usually on a Schedule E, but sometimes a Schedule C.
If you are house hacking, you can claim tax on owner occupied property. If you are not renting out part of your property or earning income from it, you generally cannot claim tax on owner occupied property.
It is best practice to keep as many receipts and invoices as you possibly can, but it is often okay to not have receipts for items that are under the IRS’ threshold.
Yes, house hacking income is just that: income. Report the rent numbers because even though that opens up the income for taxes, it also gives you the ability to write off expenses. It’s always best to keep your numbers as above board as possible.
This can still be a good ideal. Ideally you get a good property with cash flow from day one, but that is rare. If your house hacking covers the majority of expenses then property appreciation, normal career advancements, local average rents rising over time, and refinancing for better terms later all make up the difference.
The Tax Benefits of House Hacking Are Undeniable
There are many tax benefits to house hacking a property whether starting with just one or looking to expand to multiple properties in the future. Getting the most out of tax write-offs and benefits is going to play a huge part in how profitable your property is for you in addition to how possible it will be to expand in the future.
Take advantage of the tax benefits to house hacking listed in this article and you will be on your way to the best possible situation for your real estate investments… not to mention a lower tax bill.
If you’re interested in more detailed information about how taxes work for rental properties, check out this comprehensive tax guide on everything you need to know about real estate taxes.
