Accounting for House Hacking
As housing prices have increased over the years, many homeowners have turned to house hacking to reduce their living expenses. But house hacking can be more than a way to cut costs. It’s a great way to start a career as a real estate investor or property manager, plus it minimizes capital tied up in a rental property. Let’s look at what house hacking is, how to account for it, and what the tax implications are.
What is house hacking?
House hacking is finding ways to generate income by using your home. The goal of house hacking is for renters to reduce or completely cover your mortgage payments while you build equity and maintain the property. This ranges from renting out a parking spot on your driveway to renting out your house while you live in the basement apartment. If you own a multifamily property, and you live in one unit while renting out the others, you’re house hacking. Perhaps you rent out a spare bedroom, allow someone to park a boat or RV on your property, or add an accessory dwelling unit behind your house. If you have unused space in your home or on your property, you can make it profitable for you.
Renting out part of your primary residence is a great first step into real estate investing and property management. And once your house hacking income is greater than your mortgage payment, you can put the profits into savings or reinvest them. If real estate investing is for you, when your accrued equity in the property is large enough, you can refinance and use the money to purchase another investment property.
Buying a House Hack
The difference between house hacking and a traditional rental property is that you are living on the property. When you’re looking for a house hack property to buy, make sure it’s somewhere you’ll be comfortable living. As you look at properties, think about how you could use the space to generate additional income. Does a property have more storage space than you need or an in-law suite that you wouldn’t use? How much separation do you want from your renters? A duplex may be a good option for house hackers who want privacy. If the property comes with an extra parking spot or shed, you could rent it out, which would provide you with extra income while avoiding the burden of live-in tenants. But if privacy isn’t as much of a concern for you, a house with additional bedrooms may be more appealing.
The property will be your primary residence, and your mortgage rate will reflect that. Mortgage companies consider residential mortgages less risky than loans for investment properties or non-owner-occupied properties, so residential mortgages have better terms and rates for primary residences.
To qualify for most loans with lower interest rates, you must live on the property for at least one year. If you don’t use the property as asserted in your loan documents, it could constitute mortgage fraud. But after you’ve lived on the property for a year, you can move out, buy another property, and build a portfolio of income-producing properties.
But before you buy a property, check with your local housing department or a real estate attorney. Zoning laws, HOA rules, local and federal tenant protections, and occupancy rates can all affect your rental options. Remember to factor in all associated costs for your potential property when you run the numbers, including the mortgage, insurance, property taxes, common area maintenance, and operating expenses.
Bookkeeping for House Hacks
The most important part of bookkeeping for a house hack is having an effective system for tracking your income and expenses. Keeping detailed, organized records allows you to take advantage of tax deductions and mitigate tax liability. REI Hub makes it easy to keep your books, with linked accounts for importing transactions, matching rules and templates for efficiency, and financial reports available at the portfolio, property, or unit levels.
Once you have your bookkeeping system in place, you must calculate what percentage of the house is for your personal use and what percentage is for your renters. For example, if your property has four units, and you live in one of them, you occupy 25% and rent out 75% of the property. To calculate the percentages for a single-family home that you share with housemates, divide your space by the total number of rooms. You can also use the square footage for your personal space divided by the total square footage. So if you rent out two bedrooms in a three-bedroom house, 33% of the space is for your personal use. Your tenants use 67% of the house, assuming that all other rooms such as bathrooms, family rooms, and kitchens are all shared equally.
The percentages for personal use vs. tenant space are important because some costs associated with maintaining your house are deductible for house hacks. It is easiest to track your costs in their full amount in your accounting software, and then prorate based on the percentage of personal use vs rental use at the end of the year. This allows you to only worry about the proration once, as opposed to trying to prorate every expenditure on an ongoing basis.
Repairs and Utilities for the Rental Area
Expenditures incurred for the rented part of the house are deductible. So when you repair an appliance or fix a leaky sink, the cost is fully deductible. If you rent out a furnished basement apartment as a vacation rental, the amount you spend on decor, dishes, and paper towels is 100% deductible. Depending on what type of improvements you make to the rental space and how much they cost, the expenditure may be capitalized.
If you pay for utilities on behalf of your renters, that cost is fully deductible. However, if your tenants pay the utilities directly, those payments aren’t deductible.
Since REI Hub allows you to track expenses at both the property and unit level, record expenses that are 100% deductible at the unit level. Record shared expenses at the property level, then use your owner-tenant allocation to prorate the expenses at tax time.
Common Area Repairs & Improvements
Ordinarily, a new refrigerator or sofa wouldn’t be deductible. But if you rent out part of your home, and the new fridge or sofa is in the shared space, you can deduct part of the expense. Outlays for the shared areas of the house are partially deductible because both you and the tenants use the space. This is where your owner-tenant percentages come in.
So for the three-bedroom home, 67% of the cost of the new fridge or sofa is associated with shared or tenant spaces. Use your owner-tenant percentage to determine the deductible portion of any costs associated with shared areas of your house.
Similarly, a capital expenditure (depreciated over time instead of deducted) project in the common area can be prorated as well.
Repairs for Personal Use
Costs specifically associated with your personal space are not deductible. If you replaced a broken window in your room, it isn’t deductible. For the three-bedroom home with a new fridge or sofa, 33% of that expenditure isn’t deductible because it’s associated with your personal use.
To take advantage of the possible tax deductions, keep your receipts and make notes detailing what the expenses were for. Be sure to document whether an item was for your personal space, a tenant area, or a shared area.
House Hacking Tax Considerations
Renting out part of your home can change your tax situation, so it’s important to consider the implications for your financial situation before you begin house hacking. Rental activity is considered passive activity, and you may be limited in the amount of passive losses you can write off or use to offset your other income.
Reporting Income and Expenses
Income or expenses related to your house hacking venture must be reported to the IRS. Typically, you’ll use the Schedule E form to report supplemental income and loss, like rental real estate activity. Unlike with traditional rental properties, since you’re house hacking, you won’t report any personal use days on the Schedule E because you don’t have the entire property to yourself. The total taxable income or loss from your Schedule E will be recorded on your Form 1040. REI Hub offers a Schedule E Report that displays your income and expenses in the same format as the IRS form.
Also, don’t forget about depreciation! If you made improvements to the tenant or common areas that are considered capital expenditures, you will depreciate those over time and enter that deduction on your Schedule E as well. Learn more about calculating the basis of your personal property here.
Self-Employment Taxes
House hackers may also need to pay a self-employment tax if they provide services besides basic property maintenance. For example, if you include meals, transportation, tours, or concierge services for your renters, you may need to pay estimated quarterly taxes. This can also affect which tax forms you need to file—you may need to file a Schedule C instead of the Schedule E. Consult with your CPA to determine which forms apply to your situation.
Selling Your House Hack
Selling property always has tax implications. Whether you sell your solely owner-occupied personal residence or you sell a rental property, there are different and specific tax consequences for both situations. Selling a house hack property presents unique tax opportunities since it is both a personal residence and a rental property.
When it’s time to sell a rental property, the owner pays capital gains and depreciation recapture taxes. But the Section 1031 exchange (or like-kind exchange) allows a property owner to sell a business/investment property and swap it for a new property purchased for the same purpose. This allows the owner to defer capital gains taxes on the sale.
The Section 121 exclusion allows homeowners to exclude $250,000 of capital gains when they’ve lived in the property as owner-occupants for the previous two of five years. But if you are house hacking, the Section 121 exclusion will only apply to the owner-occupied part of the property. Depending on how much of your property you’ve rented out, that can seriously affect your tax liability.
Very specific rules apply to Section 1031 exchanges, and the tax implications for both Sections 1031 and 121 are considerable. Consult with your CPA or tax attorney to guide you through the process.
Takeaways
House hacking is a smart way to use your property to generate additional income. If you’re looking for a way to ease into real estate investing or property management, house hacking may be right for you. Just remember that it comes with serious tax implications and requires detailed accounting records.
