The Tax Implications You MUST Understand Before House Hacking

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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.

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.

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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.

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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.

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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!

Investors: Have any questions about the tax implications of house hacking?

Leave your comments below!

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

27 Comments

  1. Bob Ebaugh

    Hi Brandon…thanks…a very timely article. And a good excuse to ask a question.

    What happens when you move out of your unit and convert it to a rental?

    We have a triplex, lived there for a year July 1 to July 1 last year, then moved out and rented the unit. No plans to go back. We did exactly what you said here for tax year 1. For tax year 2, haven’t filed yet, but we basically started a new depreciation item for the part we originally excluded and placed it in service the day it rented and from that day forward allocated all common expenses 100% to the rental.

    Sound about right? That’s what I figured out from the IRS Pubs…..

    • Brandon Hall

      Hey Bob thanks for reading. Yes, it sounds like you have it right. I’d just report the newly rented unit on Form 4562 to start depreciating that portion of the property. All units in the triplex can be reported under one column on Sch E. Hope that helps!

  2. Adam Schneider

    @Brandon Hall —–another great article! That makes total sense (seriously). How do the tax scenarios change if instead of selling the property, you rent out the portion you were living in while rehabbing? If you intended to fix and make into a long-term (at least long enough to sell as a capital gain—-loved your articled on what determines capital gain status), can you then treat the expenses for the whole property as you would a traditional rehab/rental property?

    • Brandon Hall

      Hey Adam – thanks for reading and I appreciate the kind words. If you rent out the unit you were living in, you will simply file a Form 4562 and begin reporting the income and expenses allocable to that unit on Sch E with the rest of the property.

  3. Brian Corbett

    This is a great article, but 150K in appreciation within 3 year? I’m sure this is possible in Denver or California or something like that but not where I am investing..mid west. I understand that it was intended to be an example but wow that’s a lot of appreciation over a 3 year period.

    • Brandon Hall

      Hey Brian, thanks for reading. I don’t think $150k is much at all. Imagine you rehab a vacant duplex or triplex and hold it for three years. Not only do you have the built in equity from the rehab, but you likely now have a performing asset. $150k is doable.

      • Deanna Opgenort

        Would you have “built in equity” from the rehab? Remember you’d probably need to include the rehab cost in the basis price of the property rather than having deducted it.
        $100k property plus $70k major rehab, $200k sales price equals only $30k profit subject to capital gains. In a duplex that would be only $15k taxable profit subject capital gains assuming you lived in it for the full 3 years, correct? (the other $15k profit would be exempt, since it was your residence).

        • Brandon Hall

          Deanna – the timing of writing off a rehab doesn’t affect the amount of built in equity you have post rehab. It’s the same regardless. Additionally, you normally cannot write off a rehab and must depreciate over 27.5 years.

          You are correct on the profit splitting.

  4. Kim Coleman

    @Brandon Hall – great article! I am looking forward to our consultation next week! This article answered some of my questions and i’ll be looking for the reply to the questions above about what happens when you turn a previous househack into 100% rental. While I likely won’t sell my current home, but rent it completely, it was good to learn about the capital gains implications of househacking. I’d never ran across that information before. Thanks!

  5. mellisa otwell

    Thanks for the article. We have a rental in Portland OR that we are thinking about selling in the near future. We have been researching ways to avoid capital gains, so this article was very useful. We were thinking about having our daughter live there once she starts college and she could rent the rooms out. We considered gifting the home to her as well, but this article brought to light the implications of “house hacking”, which I was previously unaware. I think our best strategy would to either keep it and move back in for 2 years or do a 1031 exchange.

    • Brandon Hall

      Mellisa – thanks for reading. Please consult a CPA prior to moving your daughter in. That situation can cause significant limitations in exit options from a tax perspective. For instance, if you fail to charge your daughter market rent, then the home will be considered “personal use” and not eligible for a 1031.

  6. Casey Murray

    Putting a complicated issue into layman’s terms, great job. Not only can you claim depreciation on capitalized assets (i.e. roof repair), but you can claim bonus depreciation on that capital asset (i.e. potentially write off the entire asset in the year it’s placed in service vs. depreciation over the life of the asset). Note that bonus depreciation is subject to income limitations. Definitely a conversation to hold with your CPA.

  7. Michael Boyer

    A very important article.. House hacking and living in the 2-4 unit property has become a widely popular strategy and is fairly simple to execute (buy the place and manage it)…But the nature of mixing the personal residence with a rental operation requires some extra efforts and considerations that you outlined well..and you also outline the trade off nicely, especially the loss of some of the 121 exclusion that is not talked about as much as the low down payment you get as owner occupant..

  8. Albert Zheng

    Really good article. I’ve been considering house hacking as one of my initial steps to start accumulating properties. I had not considered the tax implications regarding the negatives of when you exit the property. How would you suggest analyzing the tradeoff in the loss in gains due to potential appreciation vs. money saved from income? If you were to do a 1031 exchange after converting it to a full rental, are there still tax penalties for occupying in it previously? How about if you were still occupying it with a renter and you wanted to do a 1031 exchange?

  9. Andrew Graves

    Great Article, thanks a bunch.
    You’re example showing percentages of use by area was easy to understand and helps. What about percentages by time? If you live in a single family property for say 2 years, move out and put the property in service for another 2 years and then sell, have you fulfilled the Section 121 obligations and not be obligated to pay the taxes on the $250K/500K capital gains?

    • lee liberman

      Yes in this example you are correct, However you will need to prorate the gains across years in the house. You will only get credit for the years you occupy it and up to 3 years after if you sold at the five year mark. I believe that if you rent 5 years, live 2 and rent 3, you are only entitled to half the gain exclusion (unqualified for first 5 years and then qualified for 2 living there and 3 after that). If you were to rent 8 years and live in it the last 2 before selling, you would only be entitled to 20% of the exclusion if I am interpreting the tax code correctly. Additionally, you can only use this code section once every 3 years (cant use it if you applied the exclusion on another property in last 24 months).

      • Brandon Hall

        Lee – proration is only necessary when you have previously rented the unit that you are moving into. If you owner occupy a portion of the home or a unit from day one, you would not pro rate based on previous unqualified use as there was no previous use.

        Also, you may utilize section 121 once every 2 years as that is 24 months.

        Thanks for your comment!

  10. Patrick Smith

    Wow! Thank you! I’ve been looking for this information for a while? Could you clarify the division of the house? Do you only give half credit for common areas? For example, I have a 2 BR house. Roommate would occupy smaller bedroom (approx 11×13) and I the larger (~13×15). There are a kitchen, Living Room and Dining room the roommate would have access to. Total SF is 1081. So since we each occupy 1 room and share the remaining room, would I consider it split 50/50 (~53/47 by SF) , or am I renting out 80% (1 out of 5 rooms- ~82% by SF?)

  11. kirstin rogers

    This is why I will be looking at 1031 options if and when I sell my three-flat. Great article – but one point not made – if you do not take depreciation over the years, the IRS will consider that you did, anyway, and you’ll be taxed on a benefit you did not take. 1031 though is its own headache, with tight controls and deadlines and all kinds of requirements.

  12. Valerie king

    Hi Brandon,

    Wonderful information! Thanks for sharing your knowledge!
    Can you briefly cover what would happen in taxes if, instead of selling the hacked home, you move out but start renting out the space you occupied?
    I’m considering utilizing an FHA loan to purchase a duplex, but to hold onto the property long term.
    So once I’m legally OK to move out and start renting out the space I live in, I’d like to do that.

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