What’s one of the most common things you hear mentioned when talking about real estate investing?
Location is probably number one, but a close second has to be the tax advantages. One of the things real estate investors love most about investing in real estate is the tax benefits.
But, what about house hacking taxes? Are there still tax advantages from house hacking?
In this post, I’ll explain much of what you need to know about how house hacking impacts your taxes.
Your Home Actually Giving Tax Benefits
Depending on your tax situation, you may be able to deduct your mortgage interest for the year. But, that’s likely where your tax benefits end as a traditional homeowner.
With house hacking, you’re able to take advantage of tax benefits that aren’t available to traditional homeowners.
Before I go into the options you have when house hacking, I need to provide this important disclaimer:
The information in this article, before and after this disclaimer, as well as throughout the entire Money Office Hours website, is for informational and educational purposes only. You should not see, read, or take this information as legal, tax, investment, financial, or other advice.
Why are there benefits with house hacking taxes?
The reason there are tax benefits from house hacking is because it is now a business, not just a home. Businesses have more tax opportunities available. For example, with a house hack, you can:
- Deduct expenses incurred from your rental units
- Utilize depreciation
- Use the two-of-the-last-five-years rule or 1031 exchange
If you aren’t sure what some of those bullets above mean, don’t worry – you do not need to be a tax expert to benefit from house hacking. It’s your CPA’s job to be your tax expert.
That said, it is helpful to at least high a high-level understanding of the benefits. I’ll help break down and explain the bullet points from above in the next few sections of this article.
Understanding House Hacking Taxes
There are hundreds of thousands of people whose entire career is focused on taxes. Day in and day out, all they do is focus on tax work. There are thousands, if not tens of thousands, of firms that provide this as their main service.
Not only that, but there are tons of books written about it, too.
Because the US tax code is incredibly dense and complex.
Everyone’s individual financial situation is different. For that reason, in this post, I’m covering the most important, general items related to house hacking taxes. Some may apply to you. Some may not. You should connect with a tax professional about your specific situation.
I wrote a book all about House Hacking with Simon & Schuster, which gives me the benefit of getting to talk to a lot of different people about the strategy, including house hacking taxes.
People generally quickly understand that expenses related specifically to the rental unit(s) are often tax deductible. This includes things like paint, appliance repairs, etc.
But, there are a bunch of other things that may be tax deductible.
You need to do landscaping around your house whether it’s a house hack or not, correct? In a traditional homeowner situation, those expenses likely are not tax deductible. Whereas when you’re house hacking, you may be able to write off a portion of those expenses.
The same goes for many different expenses that relate to the general upkeep of the whole building.
You usually can’t deduct the full amount, but you can often deduct an amount that is prorated based on how much of the property is a rental.
Let’s look at a real-life example of my own personal house hack that I live in right now, as I write this, to illustrate this point further.
I live in a side-by-side, townhouse-style duplex. The units are identical. Same floor plan. Two bedrooms, one bathroom.
How much of this property is a rental?
That means I can often deduct 50% of expenses that are incurred for the property as a whole, such as landscaping, snow removal, etc.
50% is a lot better than 0%, which is what you get as a traditional homeowner, but 50% is not even the best you can do.
Let’s think about a fourplex house hack. You buy a property with four units, live in one, and rent out the other three.
For simplicity’s sake, let’s assume all the units are the same.
How much of this property is now a rental?
See how this can be an awesome benefit of house hacking when it comes to taxes?
Depreciation is a concept that may seem confusing from the outside, but it’s really pretty simple.
The US Government realizes that things (buildings, etc.) deteriorate over time. They can’t last forever.
You may not notice it and you may not incur cash expenses each day or year for it, but the reality is that your roof or siding or appliances will need to be replaced a little sooner tomorrow than they did yesterday.
To incentivize real estate investors to buy properties and provide housing, the US Government allows us to use depreciation to account for that wear and tear on our properties, even if we didn’t spend any cash on fixing them yet.
As a traditional homeowner, you cannot depreciate your home at all.
As a house hacker, similar to the expenses I explained in the previous section, you can depreciate the portion of the property that is specifically used for rentals.
If it’s a duplex and half is a rental, you may be able to utilize depreciation for 50% of the building. Possibly even up to 75% of the building for a fourplex.
This first tax strategy, the two-of-the-last-five-years rule, doesn’t apply to just house hackers, but it’s worth knowing about.
According to the United States IRS, the two-out-of-five-year rule says that if you lived in a property for a minimum of two years in the past five years prior to the sale of your property, you can take $250,000 in gains tax-free for individuals, and up to $500,000 for a joint return.
Even better, you don’t have to live in the property at the time of the sale. You only have to have lived there for two years in the last five years.
One of my favorite ways to use this strategy is to house hack and live there for two years while you save up for the down payment on your next house hack. Then, once you have enough saved, you can 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 moved 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.
Just be careful about which loans you’re using, as you can only have one FHA loan at a time, and this can make things trickier.
A 1031 Exchange is a bit more of an advanced tax strategy. It’s commonly used by larger real estate investors. It’s not very difficult to understand, but it can be a bit complex.
A 1031 Exchange allows real estate investors, which you are when you house hack, to defer paying the amount owed on your capital gains from selling an investment property, so long as those gains are reinvested into another asset of “like-kind” within the IRS’ specific time frame.
One example of what this could look like is selling a house hack duplex to buy a triplex, fourplex, or similar rental property.
If you take advantage of the two-of-the-last-five-years rule that we talked about in the previous section, you won’t need to utilize a 1031 Exchange for that property, as long as your gains aren’t about the $250,000 or $500,000 limits. If your gains are higher than that, you may want to consider a 1031 Exchange.
As a traditional homeowner, the two-of-the-last-five-years rule is available to you, but the 1031 Exchange is not.
1031 Exchanges are complex and there are a lot of very specific details you must follow to do it legally. If you’re interested in utilizing a 1031 Exchange, you should connect with a tax professional and/or a 1031 Exchange professional.
Frequently Asked Questions About House Hacking Taxes
On a rental property, and a house hack, you can write off expenses related to the rental unit(s) and utilize depreciation.
Taxes work on a house hack, at least from a deduction standpoint, similar to how a business or traditional rental property does. Because your rental units are considered a business, you are often able to deduct expenses related to those rental units.
You can claim tax on owner occupied property if you are house hacking. If you are a traditional homeowner, you generally cannot.
You can claim on tax without receipts for expenses under the IRS’ threshold. It’s best to keep as many receipts as possible, but as long as you’re under the IRS’ threshold and they’re legitimate business expenses, you should be okay.
Yes, you have to report house hacking income. While you are generally able to deduct expenses, you still need to report your annual profit.