How Tax Breaks Can Turn This Real Estate Strategy Into a Gold Mine
House Hacking
Tax-filing season, which began Jan. 27, can be a source of mental and financial stress—but those who have worked smarter instead of harder have tax breaks headed their way. And that can make filing a lucrative experience.
Take the house-hacking approach, for instance. There are more than a few deductions in the offing on April 15 for taxpayers who hopped on this real estate strategy that will have made the investment worthwhile.
Because who doesn’t love generating passive income, while living rent free and getting a big tax return?
That’s why it’s important know what deductions are available before filing.
What is house hacking?
House hacking is the strategy of renting out part of the home or property you live in to help pay the mortgage or to derive passive income.
This method has been a great option for American homeowners in recent years, many of whom have been hit by inflation and high rates. While inflation has come down from its COVID-19 pandemic highs, it still stood at 2.9% in December, according to the consumer price index.
House hacking can take different forms. For example, you can rent out part of your home or just a room. You can also invest in a multifamily residence and rent one unit while living in another. Other ways to hack a house include converting a basement or installing (and renting out) an accessory dwelling unit (ADU).
The trend hit its stride in the early 2020s as, for many Americans, the dream of homeownership seemed out of reach.
Timothy Chase—financial expert, mortgage broker, and owner of 719 Lending—goes so far as to say that house hacking is “one of the smartest real estate strategies for years.”
“It’s become a go-to move for first-time investors looking to break into real estate without fully committing to being a landlord,” he says. “But beyond the obvious financial advantage of reduced living costs, the tax benefits can make house hacking even more lucrative.”
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Tax deductions for house hackers
House hacking can present different tax breaks for owners as they can take advantage of deductions on both the rental and the used portions of the property.
Chad D. Cummings, Esq, CPA, CEO, Cummings & Cummings Law, explains that this hybrid approach to homeownership brings unique tax implications that differ from traditional homeownership and real estate investing.
“House hackers can take advantage of deductions typically reserved for rental properties, making it an attractive tax strategy,” he adds, noting, however, that tax treatment depends on how much of the property is rented out and whether the property is owner-occupied for more than half the year.
Mortgage interest deduction
House hackers can take advantage of several personal-residence deductions, such as mortgage interest deductions. Cummings says that if you itemize deductions, you can deduct mortgage interest on up to $750,000 of mortgage debt for most filers—or $375,000 for those married filing separately.
Property taxes
If you are house hacking, you can deduct up to $10,000 in state and local property taxes. However, Cummings notes that rental portions of the property are not subject to this cap.
Depreciation
You can depreciate the rental portion of your home over 27.5 years.
“For example, if you own a duplex and rent out half, you can depreciate 50% of the home’s value (excluding land),” says Cummings.
These deductions enable owners “to recover the cost of their property over time,” according to Intuit TurboTax. “For owners of residential rental property, the cost is typically recovered after 27.5 years.”
Repairs and maintenance
For instance, expenses like fixing a leaky roof, repainting rental units, or replacing appliances in tenant-occupied areas are fully deductible, explains Cummings.
Utilities and expenses
Another significant deduction is the cost of utilities and services, such as internet, electricity, and landscaping.
“If these expenses benefit your tenants, you can allocate a portion of them as business expenses,” says Chase.
Home office deduction
If you use part of the home exclusively for business purposes, you may be eligible for a home office deduction, which “can be a game changer if you manage the property yourself,” Chase adds.
Selling a property you’ve hacked and the tax implications
When it comes to selling your property as a house hacker, there are several tax implications, such as the Section 121 exclusion.
If you sell your house and benefit from a capital gain, you may qualify to exclude “up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse,” according to the Internal Revenue Service (IRS).
There is a caveat, however. You must have “owned and used your home” for “at least two years out of the five years prior to its date of sale,” according to the IRS.
“Here’s where it gets tricky: Only the portion of the property used as a primary residence qualifies for the exclusion,” says Chase.
He adds that if you rented out half of your home, only the half you lived in would benefit from the exemption, while the other portion would be subject to capital gains tax.
“Strategic planning—such as living in the home longer before selling—can help house hackers minimize these tax hits,” he says.
How house hacking differs from flipping houses
House hacking and house flipping are two different real estate strategies, and both have pros and cons.
Brett Johnson, owner of New Era Home Buyers, likens house flipping to a sprint in real estate investing. House hacking is a long game in which you generate equity while covering your costs.
“But you are dealing with tenants in your living space,” Johnson says. “Flipping, on the other hand, may yield faster returns; but it comes with higher risks, market volatility, and short-term tax burdens.”
Another advantage of house hacking include its ability to help build equity over time. However, it also also requires ongoing tenant management and potential landlord responsibilities, says Cummings.
Source: Realtor.com
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