The ultimate guide to maximizing the tax benefits of the house hacking strategy.
“Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisors regarding your specific situation.”
House Hacking
House hacking is a term coined by Brandon Turner, prior host of the Bigger Pockets Podcast. When an investor is “house hacking” they are deploying a strategy known in the tax code as an “owner-occupied” rental property. Simply put, this strategy involves renting out portions of your primary residence to generate income used to offset or eliminate the cost of your mortgage and other expenses associated with owning a home.
Oftentimes, this strategy drastically reduces the investor’s cost of living and some are even able to get paid each month after all property expenses are covered. Usually, the main goal of reducing living expenses is to either need less invested assets to retire early or to boost the investors savings rate and quickly accumulate more cash to invest, increasing future passive income potential.
This guide will help you understand the tax considerations needed when implementing this strategy to help you house hack successfully and achieve your goals.
Bookkeeping
It is first important to understand that house hacking should be treated like owning your own business. Even though you should not be house hacking through a separate legal entity so that you can maintain the benefits of investing in a house as your primary residence, the success of your house hack hinges on organization and professionalism.
All businesses must have a system for bookkeeping. Having clean books & records is important for decision making, tracking profitability, and deducting expenses on your tax return. While the actual exercise can be boring or frustrating for many business owners, it has the potential to be the most impactful administrative task in your business.
The first thing you will need to do is open a separate bank account where all of your income & expenses for the property will flow through. This is best practice for anyone running a business and aids in audit-proofing your tax deductions.
The second thing you will need to do is create a system of tracking receipts. There is no point in bookkeeping and trying to deduct expenses if you do not keep your receipts since usually bank records alone do not hold up under an IRS audit. The best way to track receipts is to either attach the picture of your receipt to your transactions in your bookkeeping software, or if you prefer to do your books on a spreadsheet you can create a folder in a cloud drive where you can store the pictures of each receipt, with the title of the file being the date, vendor, and amount.
Finally, you will need to decide where you are going to do your actual bookkeeping. Some investors are very spreadsheet savvy and prefer doing their books in Google Sheets or Microsoft Excel. Others enjoy the aesthetic and ease of use of bookkeeping software, although oftentimes this comes with a monthly expense. Those who are elite in valuing their time will outsource this task to a real estate CPA who will handle setup, transaction tracking, adjusting journal entries, and bank reconciliations for them.
I recommend a new investor who is buying their first rental property as a house hack to use Stessa, which allows you to do your bookkeeping for free online. Stessa is useful for the simple investor and it has many metrics that are cool and motivating for real estate investors to track. As your rental portfolio grows, I recommend getting a real estate CPA involved in your bookkeeping as Stessa does not have proper accounting fundamentals built in for portfolios with multiple units & locations.
Reporting Income
When you are house hacking, all of your rental income is considered passive taxable income. There are deductions that can be taken against this passive taxable income that will be discussed below, but it is important to first understand the distinction between passive and active income.
Active income is the hard-earned money that one earns in exchange for performing a service or selling goods. This income is subject to normal tax rates along with the additional “self-employment” tax (the employee and employer amount of social security and medicare, 15.3%). While it may seem like you are getting punished for working hard, this kind of income is not paired with a limitation on deductions.
Passive income is the amount you earn from an activity where you do not materially participate. Rental real estate is passive by default. Even though you may spend time bookkeeping, generating rent invoices, cleaning the property, repairing the property, etc., you cannot consider this income as active (unless you are considered a real estate professional by meeting strict IRS requirements). Deductions related to this type of income are limited to the passive income earned. This means you must carry forward any expenses in excess of your rents collected for the year. However, this type of income is not subject to self-employment tax, meaning you are only taxed at ordinary income rates.
Deducting Expenses
The following list are common deductions for a primary residence:
Property taxes
Mortgage Interest
These expenses will be listed on Schedule A of your individual tax return. If those expenses combined with charitable giving, other state taxes paid, and medical expenses exceed the standard deduction (2023 standard deduction: $13,850 if you are single; $27,700 if you are married) then they count against your taxable income. Otherwise they are simply nondeductible (although you should still report them to your CPA since they may be deductible at the state level). Expenses such as association dues, cleaning, insurance, repairs, and utilities are always nondeductible for a taxpayer’s primary residence, even if the taxpayer itemizes deductions.
The following list are common deductions for a rental property:
Advertising
Association Dues
Cleaning & Maintenance
Depreciation
Insurance (including private mortgage insurance)
Legal & Professional Fees
Management Fees
Mortgage Interest
Property Taxes
Repairs
These expenses will be listed on Schedule E, page 1 of your individual tax return and are deductible against rental income.
When house hacking, these expenses must be allocated by “any reasonable method” to differentiate rental property expenses and personal expenses. If you are doing your taxes & bookkeeping yourself, I recommend allocating each expense by the square footage that is exclusive to the tenant (so if you are living in a single family residence you can only count the tenant’s bedrooms & bathrooms).
An example would be your monthly mortgage payment. If your payment is $750 per month broken out as $500 interest and $250 principal, then the calculation would be as follows:
$250 principal - nondeductible expense for both personal & rental
$500 interest X (300 square feet exclusive to the tenant / 1,500 total square feet) = $100 interest deductible as a rental expense
$500 - $100 = $400 interest deductible as a personal expense (if you itemize deductions)
Special Loss Rules
If you do not qualify as a real estate professional, you may still be able to claim some or all of your real estate losses. A special rule for those with modified adjusted gross income (MAGI) less than $100,000 can deduct up to $25,000 in passive losses. This special allowance is reduced by 50% for each dollar earned over $100,000 and is completely phased out at $150,000 (Sec. 469(i)(3)(A)).
Exit Strategy
When an investor sells their rental property they will recognize a capital gain on their tax return. Luckily for house hackers, you will only recognize a partial capital gain (assuming you did not move out and make the property a 100% rental property). IRC section 121 allows a taxpayer to exclude up to $250,000 ($500,000 for taxpayers who file a joint return) of capital gains on the sale of your primary residence if you lived there for at least two of the five years before the sale. This means that the portion of your property that was allocated to “personal” (not the house hacking portion) would receive a large reduction in capital gains.
Wrapping it up
House hacking is the single most powerful way to build wealth for new investors. Real estate investing has favorable tax benefits for those who participate in proactive tax planning. If you combine the two, you will quickly achieve your financial goals.
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