House Hacking And Its Tax Treatment
Disclaimer: The information provided in this article is for informational purposes only. We are not financial or tax advisors. You should consult with a professional in the relevant field.
What Is House Hacking?
House hacking is the practice of purchasing a primary residence (often a single-family home, duplex, triplex, or fourplex), living in one part of the property, and renting out the other parts. That “rented” portion of the house effectively generates income that can offset your monthly mortgage, insurance, and other carrying costs.
House hacking can be especially appealing for young professionals for a few reasons:
- Primary Residence Mortgage Rate: By living in the property, one can typically qualify for lower interest rates compared to an investment property mortgage.
- Reduced Living Expenses: Rental income from roommates or tenants can cover some or all of the monthly expenses.
One common question regarding house hacking is how the income from house hacking is treated from a tax perspective. Below, we’ll outline an example that illustrates how rental income and expenses are typically handled for tax purposes, followed by some more advanced considerations.
Illustrative Example
Suppose you buy a 3-bedroom house for $450,000, live in 1 bedroom yourself, and rent out 2 bedrooms to tenants. Each tenant pays $700 per month, for a total annual rental income of $16,800 (2 bedrooms x $700 x 12 months)
For tax purposes, all expenses must be “allocated”. A very simple way to do allocation might be to allocate according to the number of bedrooms: since 2 out of 3 bedrooms are rented out, the rental portion is 2/3. This allocation often applies to your mortgage interest, property taxes, insurance, HOA, utilities, repairs etc. Assume you paid $14,000 in mortgage interest, $1200 in insurance, $3,500 in property taxes, $1,800 in HOA fees, $3,000 in utilities, and $1,000 in repairs. Below is a condensed example of how these might appear on your Schedule E on your tax form:
| Operating Income (2 bedrooms) | $16,800 | |
|---|---|---|
| Operating Expenses | (2/3 portion) | |
| Mortgage Interest (2/3 portion) | -$9,333 | |
| Insurance (2/3 portion) | -$800 | |
| Property Taxes (2/3 portion) | -$2,333 | |
| HOA (2/3 portion) | -$1,200 | |
| Utilities (2/3 portion) | -$2,000 | |
| Repairs (2/3 portion) | -$667 | |
| Operating Expenses | $16,333 | |
| Net Operating Income | $467 | |
| Depreciation (2/3 portion) | -$6,667 (Illustrative; see below) |
|
| Net Rental Income (Loss) | -$6,200 |
In addition, the IRS generally allows you to depreciate the structure at a rate of 1/27.5 of its value each year. Let’s say that the house structural value is $275,000 on the property tax bill ($175,000 being the land value), annually, the house would have $10,000 of depreciation, with $6,667 attributable to the portion of rented bedrooms. This large depreciation expense can turn the $467 operating income into a net “paper loss” of $6,200. For more detailed discussion on depreciation, see our earlier post on Tax Efficiency of Rental Real Estate.
For most housing inventory in the US, “house hacking” would result in very small amount of additional taxable income annually, or even a net “loss”, due to all these prorated expenses including depreciation offsetting gross rental income. All of these allocations and depreciation details can typically be handled by self-service tax software (e.g., TurboTax) once you understand the fundamentals behind how the rental portion is split out from the personal portion. Of course, you can always consult a CPA or other qualified professional who can ensure you’re compliant and optimize the tax benefits.
Choosing a Method of Allocation
Allocating based on bedroom count is most simple, but not always most accurate or most advantageous. In practice, you can use a reasonable method to allocate which parts of your home are “rental” vs. “personal.” For many people, using bedroom count works well. Others may prefer a floor-area approach, based on the square footage of each room and calculating what percentage of the total area is rented. When allocating based on floor-area, one often deducts only the area that are strictly for rental use (such as bedroom area) and does not include common area (such as living room) in the rental portion. This significantly reduces rental portion of expenses and increases net rental income.
Why would someone like to increase taxable net rental income? Sometimes, this isn’t a choice: if the bedrooms are significantly different in size, if a basement area is entirely rented out, or maybe the garages are allocated in different proportions - floor-area allocation is simply more correct.
But purely from a tax perspective, the large “paper loss” mentioned in the previous section typically cannot be used by the tax payer to “save on taxes” anyways, because most house hackers hold W-2 salaried jobs, and these “paper losses” are considered passive loss that cannot be deducted against wage income. In these cases, choosing a smaller rental portion and a smaller paper loss has no downside from a tax perspective, but may have an upside when the house is later sold (see next section). In most coastal real estate markets with lower rent-to-price ratio, choosing a smaller rental portion using a strict floor-area method does not increase one’s taxable income, at least not meaningfully.
Selling the House
When you eventually sell a house-hacked property, you have two “buckets” of use: the part of the home used as your primary residence and the rental portion.
- Primary Residence Portion: This may qualify for the $250,000 (single)/$500,000 (married) capital gains exemption if you’ve lived there for at least 2 of the last 5 years. If your house appreciated for less than this amount, no capital gains taxes are due from the sale.
- Rental Portion: The gain on the rental portion is generally subject to long-term capital gains tax, plus any depreciation recapture for the depreciation you claimed while renting.
Again, most tax software can handle this in a self-serviced way.
It’s important to note that while the paper losses generated by depreciation are a great way to reduce or eliminate taxes on rental income during ownership, they also increase the depreciation recapture eventually when you sell. For this reason, a lower rental-portion allocation reduces annual rental write-offs, but more of your gain may qualify for the primary residence capital gains exemption when you sell, and you’ll have lower depreciation recapture. If the house is already generating paper losses using a strict allocation floor-area based allocation method, there is no need to try to optimize/increase the allocation percentage by using other methods.