When looking at your property, what are the highest expenses each year fixed or not? Typically depending on the location, it will be your taxes (considering property taxes, capital gains taxes from selling, and income taxes from the rent income). Do you do your own taxes or do you outsource it to a CPA to do them? If you do your own taxes with tax software to save money and you are a house hacker then this article is for you! Some feel paying a CPA to do your taxes is not worth it especially if you just have a couple of units and are a small landlord. a CPA might be worth it as there are a ton of rules and specifics, especially once you get into partial personal and partial business or multiple ADUs on one property, determining what expenses are write-offs, and making a substantial w2 being in a high-income bracket.
What Are The Tax Implications of House Hacking?
It is best to understand the long term tax impacts to house hacking. There are a plethora of rules and regulations to it. Sometimes when filing taxes it makes the investor wish they never did it in the first place and they just stuck with renting since Uncle Sam takes a substantial amount in some situations. Knowing how to save the most from taxes will be your best friend in these situations. Deductions and other tax rules/ tricks are some good ways to not be on the wrong side of taxes.
Tax Rules For Renting Primary Residence
Overall real estate rental income is considered passive income while your W2 is considered active income. There are specific rules and limitations that will limit passive losses offsetting active losses. There is a special $25,000 deduction, but you’re most likely phased out if you’re in the top bracket. Everyone gets taxed differently depending on what tax bracket they are in. When it comes to improvements to the property they are usually capitalized. IRS has a schedule of different ages/depreciation schedules for items. General goal is to try to capitalize as little as possible to get the repair deduction in the same year. when you house hack, you designate a portion of your property as a rental. You take depreciation on that designated portion each year. Essentially there are depreciation of parts of house expenditures like roofs, appreciation of house and rental income as some ways to make money from real estate. Your ultimate goal should be to minimize your tax liability to keep compounding the money back into real estate or other investments.
Tax Deductions For Renting Primary Residence
If you are living in a property and renting out a portion of the house or any part of it your taxes you file annually needs to reflect that. From a tax perspective if you live in only 25% of the building that 25% will be considered your personal residence. Then the other 75% of the building will be considered your rental property when you file your taxes. Therefore, the expenses you use for the property 75% will be a part of schedule E (investment documentation when filing) and the 25% of the expenses will be schedule A (personal side of situation).
Insurance expenses for a primary expense is non deductible for primary residence, however for an investment property (the portion of your house rented out) it can be deducted as an investment expense. The same can also be applied to taxes and mortgage interest for the property. This can cause problems if the amount allocated for personal use is not substantial enough to get any deductions.
This does take a lot of work to itemize deductions and keep track of the write off expenses over the year. Especially when you are taking in consideration maintenance and repairs it will also be split as well between respective percentage personal vs investment. It is important to note any repairs 100% only done to your personal living quarters that those expenses can not be deducted from your taxes since it is personal and not investment. Furthermore, in some situations expenses might be in common areas and these expenses will be split too respectively to % to rented out vs live in.
It is highly recommended to keep a running list of the expense and how much will be allocated to the rental portion throughout the whole year to make your life easy once it is time to file taxes for the year. Even if you hire a CPA to do your taxes he will need a compiled list of expenses for the investment property.
Renting Your Primary Residence Taxes
Primary residence rental or house hacking means the residence is completely considered your personal residence on your tax return. You just happen to rent out one side or rooms.
As an example: You own a duplex and live in one half, renting the other half. Both units are approximately the same size. Last year, you paid a total of $10,000 mortgage interest and $2,000 real estate taxes for the entire property. You can deduct $5,000 mortgage interest and $1,000 real estate taxes on Schedule E (investment). If you itemize your deductions, include the other $5,000 mortgage interest and $1,000 real estate taxes when figuring the amount you can deduct on Schedule A (personal).
Renting Out Primary Residence Capital Gains Tax
If selling your primary residence when also using it as a rental property it is important to keep in mind Section 121 exclusion. Section 121 exclusion is if you own a property and live in the property for 2 years you can exclude 250k of capital gains from the sale of the property (500k if filing jointly). There is a 5 yr time frame limit on this after moving out. Ie- live in a property 4 years and then sell property after 6 years means you will not qualify for the capital gains tax exclusion. However, if you live in the property for 2 years then are moved out for 4 years it will work out to be tax free. This is a very powerful tax tool when house hacking. Also, the capital gains exclusion is only the % you lived in and not the rental portion. In some situations it might not make sense to house hack vs rent when looking at taxes especially if the taxes become a burden and end up being more expensive than renting when taking into tax liability when selling a property.
Room Rental Expense Write off Example Renting Primary Residence Tax
Let’s say you are renting a room in your primary residence, which is 19×10 feet, or 190 square feet. Your entire house has 1,900 square feet of floor space. You can deduct as a rental expense 10% of any expense that must be divided between rental use and personal use. If your heating bill for the year for the entire house was $600, $60 ($600 × 0.10) is a rental expense. The balance, $540, is a personal expense that you can’t deduct.
Another example in a primary residence tax write-off situation is if you replaced a broken fan in one of the rooms, you could write 100% of that off. However, If you replaced a dishwasher, you could write off a portion of that expense since it’s being used by both you and as well as your tenants/housemates.
In Conclusion
Throughout living in your primary residence rental property it is important to keep track of all your expenses and split the cost for 100% write-off or only a percent for the rental part of the property. It is important to keep in mind capital gains tax when selling and also the ways around it. More information can be found in the IRS Publication 527 around depreciation and rental Income tax rate.
