Renting out a portion of the home you own and live in––whether it be one or more units in a multi-family property or rooms in a single-family house––is a great way to jump-start your real estate investing portfolio. Owner-occupying, or house hacking, can help you generate some extra cash or even live for free.
This photo, “Money House”, is copyright (c) 2013 401(K) 2012 and made available under an Attribution-ShareAlike 2.0 Generic (CC BY-SA 2.0) license
If renting out a portion of your personal residence is something you’re currently doing or plan to do, it is extremely important to be aware of the tax implications.
Why?
Because the tax treatment deductibility of expenses for your personal residence and for a rental property are very different.
Personal Residence vs. Rental Property
Generally, most expenses paid in relation to your personal residence (e.g., insurance, utilities, electric, internet, HOA, repairs & maintenance, etc.) are not deductible…at all. Not cool. There are some expenses, however, that are deductible on Schedule A (i.e., property taxes and mortgage interest) if, and only if, you itemize…for now.
The same expenses that are disallowed on a personal residence are allowable deductions on Schedule E for a rental property, which means they effectively reduce your taxable rental income. That goes for property taxes and mortgage interest, as well. Cool.
Now that we can see the difference between the two classifications and why it’s important to distinguish between the two, let’s check out the most common deductions and how to apply them to an owner-occupied living situation.
But first, one piece of advice…
Before we dive into the world of Narnia tax deductions for house hackers, let the accountant in me offer an annoying, but very important and useful recommendation:
KEEP DETAILED RECORDS OF ALL YOUR RECEIPTS!
Sorry…didn’t mean to yell…got a little carried away.
The reason I stress this point is because when tax time rolls around, it’s impossible to remember what you bought at Home Depot for $42.08 on June 15 of last year, and you may miss out on a possible tax deduction simply because you didn’t keep a record of it.
Anyway, where was I?
Oh, yeah, tax deductions…
Tax Deductions for House Hackers
The first step in determining which tax deductions you can take is determining which percentage of the home is occupied by you and which percentage is occupied by the tenant(s). For example:
- If you own a 4-plex, live in one of the units, and rent out the other three, you occupy 25% and rent out 75% of the property.
- If you own a 3 bedroom single-family home, live in one room, and rent out the remaining two, you occupy 33% and rent out 67% of the property (this is assuming all other rooms, such as bathrooms, kitchens, living rooms, etc., are all shared equally). You can also use a square footage ratio instead of a room ratio.
Remember – rental expenses are deductible on Schedule E and, generally, personal expenses are nondeductible. Personal expenses that are are deductible are reported on Schedule A. Let’s run through an example with some numbers.
Here’s the scenario: You bought a 4-plex for $600,000 and live in one unit, so your personal use is 25% and rental use is 75%. Your total rental income for the year is $54,000 and your annual expenses are as follows:
| Expense | Annual Total | Deductible on Schedule E | Deductible on Schedule A | Nondeductible |
| Property taxes | $15,000 | $11,250 | $3,750 | |
| Mortgage interest | $35,000 | $26,250 | $8,750 | |
| Insurance | $1,000 | $750 | $250 | |
| Utilities paid by tenants* | $7,000 | $7,000 | ||
| Utilities paid by you for your personal unit | $2,500 | $2,500 | ||
| Maintenance and repairs to rental units | $3,000 | $3,000 | ||
| Maintenance and repairs to personal unit | $500 | $500 | ||
| Maintenance and repairs to “common areas” (used by both you and your tenants) | $2,000 | $1,500 | $500 | |
| Other “common area” expenses paid by you (garbage, snow removal, landscaping, etc.) | $1,500 | $1,125 | $375 | |
| Depreciation** | $13,000 | $13,000 | ||
| Total | $80,500 | $56,875 | $12,500 | $11,125 |
*If utilities were paid by you on behalf of your tenants, they would be fully deductible on Schedule E.
**Depreciation is only allowed on the rental portion of your property but, instead of applying the personal/rental percentages to the depreciation expense, you apply it to the value of the property before computing depreciation. Continuing with the above example: Purchase price = $600,000. Separate the value of the building and land (land is not depreciable) – building = $480,000; land = $120,000. Rental portion of the building (75%) = $360,000. Rental real estate is depreciated over 27.5 years, so the annual depreciation would be roughly $13,000, which is fully deductible on Schedule E. The same concept applies to capital expenditures (e.g., new roof, replace a boiler, major repairs, etc.).
So, what does this all mean?
Now that you read through my nifty table, let’s analyze the numbers…
Gross rents = $54,000
Total rental expenses, before depreciation = $43,875
Net income, before depreciation (cash flow) = $10,125
Depreciation = $13,000
Net loss (no taxable rental income) = $2,875
Allow me to translate…
You cash-flowed $10,125 for the year (which pays for almost all of your nondeductible living expenses). Nice!
And even better, after taking depreciation, you eliminated the taxable income of $10,125 and turned it into a net loss of $2,875. That’s right, you pocketed $10,125, TAX-FREE. Really nice!
Two important things to remember, however…
- Rental income and losses are considered passive, which means you may not be able to use all or any of the losses generated from rental activity to offset your other income.
- Selling the property could cause some tax problems if proper planning and strategies are not implemented.
The above two topics are outside the scope of this post, but I urge you – please talk to your CPA if either of the above currently or will apply to you and discuss possible strategies to make sure you either pay as little taxes as possible or get the most money back.
Remember, tax evasion is illegal, but tax avoidance is perfectly legal.
The Bottom Line
House hacking is an awesome way to build your rental portfolio, manage properties, and live for cheap (or free). It’s a great strategy, especially for beginners. It’s super important to be aware of the different tax treatments of personal and rental deductions relating to your owner-occupied property because you certainly don’t want to leave any money on the table for Uncle Sam.
As good as the tax deductions may be, keep in mind that there could be certain pitfalls when house hacking. I will dive into this further in a future blog post.
Want to chat about your house hacking adventures? Drop a line below or reach out to us directly! You know where to find us 👇
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Aiola CPA, PLLC is a 100% virtual CPA firm, specializing in tax planning and preparation for real estate investors. See more at www.aiolacpa.com
Hey Nick, great article definitely helped shed some light. I bought a 3 family with fha loan, and will live in 1 apartment. The other 2 are currently rented out and have been since I bought the house. Few questions below –
1. My insurance company made me replace the roof on the detached garage and part of the roof on the actual house. Cost a pretty penny. Can I write that off?
2. The apartment I was going to move into needed a complete remodel. Found mold and old termite damage and leaking/water damage. Ripped out rugs and put new floor throughout, tore down some walls and put some new walls up and all new sheet rock on basically every wall. Also all new recessed lights and some other electrical work. Even tho I am living in it for a year but will rent it out after my fha restriction is up, are any of those expenses able to be written off?
3. Also replaced a water heater that is shared with the apartment I live in and the first floor apartment. Any write off for that?
Thanks in advanced!
Glad it helped!
1. Costs for common area expenses (such as the roof on the house; not sure if the detached garage is shared or not) must be prorated between rental and personal. The rental portion is deductible; the personal portion is not.
2. If it’s all for your personal unit, it will not be deductible, but hang onto the receipts! It could be added to basis if you move out and convert the unit to a rental, or reduce the gain if you sell in the future.
3. Same as #1.
Hey Nick, great article. A couple questions:
My wife and I are building a new home with the intention to rent out a separate mother-in-law suite above the garage. We currently live in a condo we own and will sell it soon after the construction is complete.
1. Could we do a 1031 exchange on the sale of the non-rental condo to the new house-hacked home?
2. If the renter (think college student) occasionally watches our dogs while we are away or gives us a hand with our other businesses and thus spends some time in our home (kitchen, living room, etc), can I consider this common area and treat it as such regarding tax deductions?
3. Since the MIL suite would be the rental space, can depreciate that portion of my home?
Thanks in advance!
Thanks! Great questions.
1. You cannot do a 1031 exchange if the relinquished property is not held for investment, even if the replacement property will have an investment component.
2. If you have a tenant paying fair market rent for the area they are occupying, you can deduct a portion of the common area expenses against that rental income.
3. Yes, the % of the home that is used for business (rental %) can be depreciated.
Question through an example:
You buy a 4-Plex on Jan 1. You move into 1 of the units and spend $100,000 on renovating the other 3 units. You move tenants in on 4/1 after renovations are complete. Can you claim the renovations as deductions even though the units weren’t actually rented when you renovated them from 1/1 – 4/1?
It depends on a couple of things:
1. The in-service date (when the property was livable and first advertised for rent) – expenses incurred before the in-service date are added to basis and depreciated; expenses incurred after the in-service date can generally be deducted as operating expenses.
2. The cost of the individual repairs – expenses under the de minimis threshold ($2,500) generally can be expensed; anything over $2,500 typically must be capitalized and depreciated.
I think house hacking is great, but what happens with the depreciation once you stop house hacking and rent out the other portion? How do you now depreciate the portion of the unit you had been house hacking?
Jennifer – I believe I just answered your husband’s same question on BiggerPockets (what a coincidence that would be if it weren’t your husband!), but I’ll reiterate here for you 🙂
When you acquire the property, the full amount of the basis (inclusive of your personal unit) should be capitalized, but the business use % of the asset would be 50%. When you move out, it would then become 100% and depreciation would calculate normally. No additional asset should be added to represent the “new” rental unit since it’s really the same building.
Hey Nick,
I apologize for the multiple posts, but another few question: when you say “net loss”, is this because you own an asset worth a certain amount that cash flowed $10,125 but that same asset depreciated by $13,000 (more than what you brought in)?
2) let’s say all else stays the same, but you increase rents next year allowing your net income before depreciation to increase to $20,000. I’m assuming that means you now have a net gain position of $7,000 after depreciation. How do the tax implications work in this case?
Dan
Dan,
Great questions!
1. Not everything is depreciated via the straight line (SL) method. In fact, the only assets that are required to use SL depreciation are the property itself and capital improvements (e.g., a new roof). Other assets are depreciated using either the 200% or 150% declining balance method, both of which are more accelerated than the SL method. Click here for more details.
2. As far as the net loss goes, that’s strictly from a tax perspective, so the asset worth doesn’t really have much to do with it, aside from the fact that the asset worth determines the depreciation. It’s all about the income and expenses. You’re exactly right – the net loss is generated because the depreciation is higher than the net cash (income) you brought in.
3. Correct. That would result in a net taxable gain of $7,000, which would be taxed at ordinary rates. However, real estate losses are “passive” and can’t be used to offset nonpassive income (e.g, W-2 income). For the sake of argument, let’s say in Year 1 you have a net loss of $2,875 and no other passive income. That loss would be carried over to Year 2. If, in Year 2, you have a net profit after depreciation of $7,000, you will be able to use the net loss from the prior year to offset some of that income, meaning you’d only be taxed on $4,125 ($7,000 – $2,875).
Hope this helps!
Hey Nick,
Great article. I was wondering: do you know whether or not all real estate related capital assets are depreciated via straight line methods?
Dan