House hacking is a popular term tossed around here on the BiggerPockets Forums. It means that you are going to buy a multi or single family dwelling and rent out the units or rooms that you are not occupying. The idea is to live for free, as the renter’s rents will cover your mortgage payments. Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free With any strategy, there are multiple aspects to consider, as there are always pros and cons. Savvy real estate investors understand that tax implications should always be analyzed since they will show you the true return on your investment. The post-tax net present value (NPV) of their bottom line is what truly matters. While house hacking is certainly an excellent strategy, few people tout and further understand the tax implications that come along with it. If you aren’t taking the tax implications into account, or worse, if you’re failing to report the rental income you are receiving, house hacking could put you in an inferior position with respect to your NPV as opposed to forgoing house hacking. That’s fancy talk for saying the tax issues arising when you sell a house hacked property may come back to bite you. Allocating Personal and Business Expenses First, you must determine what percentage of the property is occupied by you and occupied by the tenant. If you have multiple units, you simply divide your unit by the total number of units. If you have a single family home, you can either divide the room you occupy by the total number of rooms (rooms include beds, baths, kitchen, living room, dining room, etc.) or the square footage you occupy by the total square footage. You will now have a percentage of the home that you occupy and a percentage of the home that you rent. Costs associated specifically with the space you occupy (such as replacing a window to your personal room) are non-deductible. Treat this expense as you would a personal residence. However, costs incurred in regard to the rented portion or common areas of your homes are either fully or partially deductible based on the ratio we just calculated. More on that in a bit. Two added benefits of renting out your home are that you can depreciate the portion of the home you don’t personally occupy and you can deduct normally non-deductible expenses for owner-occupied properties, such as insurance costs. You will use the ratio determined above to allocate these expenses. As an example, if you could normally depreciate your property by $10,000 and you occupy 10% of it, you can depreciate your property $9,000. Capitalizing & Deducting Repairs and Other Expenses Let’s say you have to replace a roof. On a primary residence, you don’t get to take a depreciation deduction on your new roof in future years. However, on a house hacked property, the cost basis of the roof is allocable to both the owner-occupied and the rented portion of your home. This means you will get to depreciate a portion of the roof every year. Piggy backing on the example above, if a new roof costs you $6,000 and you occupy 10% of the property, $5,400 of the roof’s costs will be added to the rental basis and depreciated each year. That’s a big bonus! Repairs are a bit trickier. First, you cannot deduct repairs made to the portion of the property you personally occupy. Second, you must use the ratio determined above to determine the amount of repairs you can write off for those made to common areas. And third, you can fully deduct repairs made to the rented areas. For example, let’s assume you repaired 10 windows during the year. Two windows are attached to your personal room, four are attached to rented rooms, and four are attached to common space areas. The repairs made to the two windows attached to your room are non-deductible, whereas those made to the four windows of the rented rooms are 100% deductible. The repairs made to the windows attached to common areas are only partially deductible, based on the ratio of occupied-to-rented space. But what if you provide furnishings? Can you also deduct the costs of those furnishings? Of course you can. If you buy dishware, utensils, provide appliances, furniture, tables, chairs, etc., the expenses for all of those items can be partially deducted based on the ratio I’ve been harping on throughout this article. It’s important to keep receipts for any asset you buy that will be utilized in the common area of your rental. This can result in huge tax write-offs at year end. Now for the Negatives Do not, I repeat, do not undergo house hacking without 100% understanding the tax implications. As I’ve described above on a high level, there will be sweet tax benefits of house hacking. But there are also really large negatives that you need to be fully aware of. When you house hack, you are effectively treating one property like two — the owner occupied portion and the rented portion. The owner occupied portion will be treated as it normally would, and expenses will be reported on Schedule A, while the rental portion will be treated as a rental normally would, and expenses will be reported on Schedule E. The key here is that the rental portion is a passive activity, and you may be limited in the amount of passive losses you are able to write off. This is significant because things like interest expenses on your mortgage payment may become not fully deductible. Where you could normally deduct 100% of the interest expense on Schedule A for an owner-occupied property or 100% on Schedule E for a rental property, you must now split the expense amongst the owner portion and the rental portion. If we assume you occupy 10% of the property, you can only report 10% of the mortgage interest on Schedule A, and the remaining 90% will be reported on Schedule E. The first question is: Will the expenses you report on Schedule A be large enough to itemize? If not, you lose out on deducting a portion of that expense. The second question is: if your rental shows a passive loss, will you even be able to deduct that loss? If not, you lose out on that deduction where you would normally take it in full on Schedule A if you 100% occupied the property. The same issue will arise with property taxes. Selling Your House Hacked Property Will Cause Problems Two huge issues arise when you sell a rental property: capital gain and depreciation recapture taxes. This is why there is a large market for 1031 exchanges, cost segregation, and other tax deferral strategies. As we’ve already discussed, when you house hack, you designate a portion of your property as a rental. You take depreciation on that designated portion each year. Unfortunately, when you sell, you have to pay a tax on the depreciation you took over the years. Additionally, you will incur capital gain taxes assuming you indeed sell for a gain. The combination of capital gain and depreciation recapture taxes can add up fast. The problem here is that by house hacking, you chose to forgo the sexiest tax deduction available for people who own real estate — the Section 121 exclusion. This exclusion allows you to exclude from taxable income $250k ($500k if married filing jointly) of capital gains if you’ve lived in the property as an owner-occupant for the previous two of five years. The good news is that you will get to apply the Section 121 exclusion to the portion of the home you owner occupy, but you will unable to apply it to the portion of the home that is rented. Let’s say 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 area has appreciated and you are going to net, after selling costs, $150k. Ten percent of the property will qualify for the Section 121 exclusion, while the remaining 90% will be subject to depreciation recapture and capital gains tax. Assuming you’ve taken $25k in deprecation over the last three years and you are subject to a 15% capital gain tax rate, you’re looking at roughly $26k in taxes. If you live in an area set to appreciate over the next few years, your decision to house hack can literally cost you thousands more than what you’d save each month by renting out other rooms. In our example, you would need to rent the rented portion for $722 ($26k/36 months) per month to break even on the decision. This is, of course, very simplistic, but the point is to consider all alternative scenarios before making a decision. Conclusion House hacking is a phenomenal strategy that I think everyone should seriously consider. It’s a great way to live for free and build significant amounts of wealth in a relatively short period of time. But there are pitfalls, and these pitfalls need to be analyzed carefully and factored into your decision making. Tax write-offs present themselves while you own the asset but could become a huge pain when you go to sell. Keep that in mind before jumping into a house hacking adventure! [Editor’s Note: We are republishing this article to help out our newer readers.] Investors: Have any questions about the tax implications of house hacking? Leave your comments below!