Renting out a portion of the home you own and live in––whether it be one or more units in a multi-family property or rooms in a single-family house––is a great way to jump-start your real estate investing portfolio. Owner-occupying, or house hacking, can help you generate some extra cash or even live for free.
If renting out a portion of your personal residence is something you’re currently doing or plan to do, it is extremely important to be aware of the tax implications.
Because the tax treatment deductibility of expenses for your personal residence and for a rental property are very different.
Personal Residence vs. Rental Property
Generally, most expenses paid in relation to your personal residence (e.g., insurance, utilities, electric, internet, HOA, repairs & maintenance, etc.) are not deductible…at all. Not cool. There are some expenses, however, that are deductible on Schedule A (i.e., property taxes and mortgage interest) if, and only if, you itemize…for now.
The same expenses that are disallowed on a personal residence are allowable deductions on Schedule E for a rental property, which means they effectively reduce your taxable rental income. That goes for property taxes and mortgage interest, as well. Cool.
Now that we can see the difference between the two classifications and why it’s important to distinguish between the two, let’s check out the most common deductions and how to apply them to an owner-occupied living situation.
But first, one piece of advice…
Before we dive into the world of
Narnia tax deductions for house hackers, let the accountant in me offer an annoying, but very important and useful recommendation:
KEEP DETAILED RECORDS OF ALL YOUR RECEIPTS!
Sorry…didn’t mean to yell…got a little carried away.
The reason I stress this point is because when tax time rolls around, it’s impossible to remember what you bought at Home Depot for $42.08 on June 15 of last year, and you may miss out on a possible tax deduction simply because you didn’t keep a record of it.
Anyway, where was I?
Oh, yeah, tax deductions…
Tax Deductions for House Hackers
The first step in determining which tax deductions you can take is determining which percentage of the home is occupied by you and which percentage is occupied by the tenant(s). For example:
- If you own a 4-plex, live in one of the units, and rent out the other three, you occupy 25% and rent out 75% of the property.
- If you own a 3 bedroom single-family home, live in one room, and rent out the remaining two, you occupy 33% and rent out 67% of the property (this is assuming all other rooms, such as bathrooms, kitchens, living rooms, etc., are all shared equally). You can also use a square footage ratio instead of a room ratio.
Remember – rental expenses are deductible on Schedule E and, generally, personal expenses are nondeductible. Personal expenses that are are deductible are reported on Schedule A. Let’s run through an example with some numbers.
Here’s the scenario: You bought a 4-plex for $600,000 and live in one unit, so your personal use is 25% and rental use is 75%. Your total rental income for the year is $54,000 and your annual expenses are as follows:
|Expense||Annual Total||Deductible on Schedule E||Deductible on Schedule A||Nondeductible|
|Utilities paid by tenants*||$7,000||$7,000|
|Utilities paid by you for your personal unit||$2,500||$2,500|
|Maintenance and repairs to rental units||$3,000||$3,000|
|Maintenance and repairs to personal unit||$500||$500|
|Maintenance and repairs to “common areas” (used by both you and your tenants)||$2,000||$1,500||$500|
|Other “common area” expenses paid by you (garbage, snow removal, landscaping, etc.)||$1,500||$1,125||$375|
*If utilities were paid by you on behalf of your tenants, they would be fully deductible on Schedule E.
**Depreciation is only allowed on the rental portion of your property but, instead of applying the personal/rental percentages to the depreciation expense, you apply it to the value of the property before computing depreciation. Continuing with the above example: Purchase price = $600,000. Separate the value of the building and land (land is not depreciable) – building = $480,000; land = $120,000. Rental portion of the building (75%) = $360,000. Rental real estate is depreciated over 27.5 years, so the annual depreciation would be roughly $13,000, which is fully deductible on Schedule E. The same concept applies to capital expenditures (e.g., new roof, replace a boiler, major repairs, etc.).
So, what does this all mean?
Now that you read through my nifty table, let’s analyze the numbers…
Gross rents = $54,000
Total rental expenses, before depreciation = $43,875
Net income, before depreciation (cash flow) = $10,125
Depreciation = $13,000
Net loss (no taxable rental income) = $2,875
Allow me to translate…
You cash-flowed $10,125 for the year (which pays for almost all of your nondeductible living expenses). Nice!
And even better, after taking depreciation, you eliminated the taxable income of $10,125 and turned it into a net loss of $2,875. That’s right, you pocketed $10,125, TAX-FREE. Really nice!
Two important things to remember, however…
- Rental income and losses are considered passive, which means you may not be able to use all or any of the losses generated from rental activity to offset your other income.
- Selling the property could cause some tax problems if proper planning and strategies are not implemented.
The above two topics are outside the scope of this post, but I urge you – please talk to your CPA if either of the above currently or will apply to you and discuss possible strategies to make sure you either pay as little taxes as possible or get the most money back.
Remember, tax evasion is illegal, but tax avoidance is perfectly legal.
The Bottom Line
House hacking is an awesome way to build your rental portfolio, manage properties, and live for cheap (or free). It’s a great strategy, especially for beginners. It’s super important to be aware of the different tax treatments of personal and rental deductions relating to your owner-occupied property because you certainly don’t want to leave any money on the table for Uncle Sam.
As good as the tax deductions may be, keep in mind that there could be certain pitfalls when house hacking. I will dive into this further in a future blog post.
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Aiola CPA, PLLC is a 100% virtual CPA firm, specializing in tax planning and preparation for real estate investors. See more at www.aiolacpa.com