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Property Management Blog
More Chicago Investor Resources

6 MUST KNOWS FOR PAYING TAXES WHILE HOUSE HACKING

Aaron Zimmerman - Friday, November 20, 2020

We have talked about the power of househacking multiple times on the podcasts
and why it may make sense for someone looking to get started in investing (and
make sure to check out the Househacking Calculator under our Resources Tab). If
you’re just getting up to speed, house hacking is a strategy that entails
renting out some or all of your primary residence to generate rental income that
can be used to offset the mortgage and other expenses associated with home
ownership. I have personally done this strategy and I would like to highlight
the key items you need to know from a tax perspective when it comes to
househacking. This article will help you better understand the tax benefits of
real estate and how these benefits apply specific to house hackers.

DETERMINING BASIS

Per the IRS, basis is the amount of your capital investment in your property for
tax purposes. This will come into play when you claim depreciation for your
property (discussed in a section to follow). The majority of the below items
that go into basis will be found on your closing statement. Items that go into
this include, but are not limited to:

* Purchase price

* Credits from the seller

* Title Fees

* Recording Fees

* Attorney fees

* City/county specific taxes

* Any other costs needed to purchase the property (i.e. scoping of sewer lines,
paying an electrician to inspect the property)

Once you determine your basis, you will allocate the basis between building and
land. The most common way to allocate between building and land is to look on
your local county assessor’s website. For an example in Cook County, see below.
You will find the total assessed value, land assessed value, and building
assessed value. You will take the building’s assessed value and divide it by the
total assessed value to come up with the percentage of the value that should be
allocated to the building. You will do the same step for land. The building
portion is depreciable whereas land is not. They will list out the building and
land values.

Example

The below was used to calculate the basis of the property.

The next step is allocating between building and land by going to the assessor’s
website.. Using the above, 81% of the basis will be for the building
($6,930/$36,236) and the remaining 19% will be allocated to land. Therefore,
$494,100 will be allocated to building and $115,900 will be allocated to land.

ALLOCATING BETWEEN RENTAL AND PERSONAL

The next step is to determine the portion of the building and land that is for
rental use versus personal use. The reason why we are doing this is because we
are an owner occupant and therefore can not take 100% of the depreciation.

The two common ways to allocate between rental and personal use are by bedrooms
or square feet. If there is an appraisal, the square footage of each unit will
be listed. If there is no appraisal, you will need to measure yourself or find
an alternative method. A best practice would be calculating both to see which
method is most advantageous. You will also want to document the approach you
used and use numbers to back up your decision in case your tax return is
audited. This calculation will also be used for determining how expenses are
allocated between rental and personal uses.

Example

The property used above is a four unit property. Let’s assume that there are ten
total bedrooms, of which two rooms are in the unit you will be living in. You
would be able to get 80% allocated for rental. The other option is to go by
square feet. Let’s say that after measuring, each unit is 1,000 square feet and
therefore the house is 4,000 square feet total. Therefore, the rental section is
75%. As such, we will elect to take the most advantageous method. In this case,
that would be the 80%.

Now, we can piece this together to formulate the amount that we can depreciate
on our return. The building percentage that will be allocated to our rental will
be $494,100 multiplied by 80% which totals $395,280. The land that will be
allocated to our rental will be $115,900 multiplied by 80%. The amounts below
that are “personal” will not be included on our return. What happens to that
will be discussed in the next section.

DEPRECIATION

Depreciation is one of the biggest benefits of real estate. It is a “paper”
expense. The government is saying that since you bought this property, you are
able to deduct some of the costs related to the building over what the IRS deems
to be its useful life (27.5 years). This depreciation allows you to shield your
income that you make from the property. For the house hack, you will be able to
claim depreciation on the amount that is related to the rental during the time
that you live there (see above for how to allocate between rental and personal).
After moving out and advertising the unit you will be able to depreciate your
unit too, which means you will be able to claim more depreciation. If it weren’t
for this benefit, many real estate investors would be paying a lot more in tax.

EXAMPLE

The amount of depreciation on an annual basis would be the “building rental”
listed above divided by 27.5 years. As such, you will get $14,374 ($395,280/
27.5 years) in yearly depreciation from your rental during the time that you
live in the property using the above numbers. When you move out and advertise
the unit, you will get additional depreciation on the personal unit you are now
renting out.

CALCULATING EXPENSES

At the end of the year, you’ll want to make sure you’ve gathered all your
receipts and adequately categorized your expenses so you can take as many
deductions as legally allowed. The biggest thing to be aware of is allocating
the expenses properly between personal and rental uses as well as among units. A
few examples:

Example 1: Throughout the year, there are various repairs and maintenance issues
that come up in unit #2 of your rental (note: this is not the unit you’re
occupying). Assuming these relate 100% to unit #2, these expenses should be
allocated 100% to your rental for unit #2.

Example 2: During the year, you will pay your water bill. GIven that this is a
utility that’s used by every unit, you would allocate based on the percentage
that you have prescribed (i.e. bedrooms or square feet). You would not be able
to expense the portion that allocates to your unit.

PROPERTY TAXES

This section primarily applies to the first year of purchase. In some areas of
the United States, counties assess taxes in arrears (i.e. paying 2019 taxes in
2020). If this is the case, you will receive a property tax credit on your
closing statement. If you receive a property tax credit in excess of the amount
you have to pay for that year, you will not be able to claim a tax deduction for
property taxes. However, if your property tax credit is less than the amount
that you pay, you will be able to claim the excess. This is best explained
through the below examples:

Example 1:

In May 2019, you purchase your first house hack and receive a property tax
credit for $6,500. The amount that was paid by you in 2019 was $6,300. In this
instance, you will not be able to deduct the $6,300 paid and you will need to
credit the excess of $200 forward to the following year’s tax return to be taken
as a credit.

Now, let’s say in 2020, you pay $8,000 in taxes. You would be able to deduct
$7,800 (8,000-200).

Example 2:

In February 2020, you purchase your first house hack and receive a property tax
credit for $4,000. The amount that was paid during 2020 was $5,600. In this
instance, you would be able to deduct $1,600 on your 2020 return.

DETERMINING YOUR TAX IMPACT

Using some of the numbers from the above, mainly depreciation, I have created
the below example. Please note that rents received is a positive number and
expenses are being subtracted from rents received to get to a net loss of
$3,374. This means that after all income and expenses, your expenses are higher
than your income. Ordinarily, you would not be able to deduct this loss as this
is considered passive income for the purposes of the IRS. However, there is a
provision within the tax code that allows small landlords to deduct up to
$25,000 against ordinary income (i.e. W-2 income). You have to meet three
conditions. First, you have to make below $150,000 in adjusted gross income
(AGI). Second, you have to be a non-real estate professional who owns at least a
10% interest in the property. Third, you must actively manage the subject
property.

For the income limitation, you have to be at $150,000 in adjusted gross income
or less to qualify for the deduction. Here is how it works. If you make less
than $100,000, you can claim up to $25,000 in losses. If you make above
$100,000, the loss is phased out at $2 for every $1. What this means is that if
you make $125,000, you can claim up to $12,500 in rental losses. If you make
over $150,000 in adjusted gross income, you cannot qualify for this deduction.

For the 10% interest in the property, this means that you own more than 10% of
the property. For example, if you are using FHA financing, put down the minimum
down payment of 3.5%, and have no partners, you would still qualify because you
are entitled to 100% of the benefits.

For active participation, this means that you are meaningfully involved in
making management decisions. Such decisions would include: approving tenants and
selecting contractors or vendors. There are certainly more decisions that the
landlord makes but these are two common examples.

Assuming you have met the qualifying criteria of this carve out, you would be
able to deduct $3,374 against your active income. This could save you
significant money depending on what tax bracket you’re in..

WRAPPING IT ALL UP

With house hacking, there are additional tax considerations and there are many
important steps that must be taken to get an accurate assessment of your
potential tax impact. If you are planning on doing this yourself, the above
should be helpful. If you are outsourcing to a CPA, you will want to make sure
that they calculate the basis correctly and that they understand the living
arrangement so expenses can be allocated appropriately.

If you have questions on your real estate tax strategy, you can reach me (Aaron
Zimmerman) at aaronz@thethinkers.com.

Additional Resources:

Cook County Assessor Website

1040 Schedule E

Adjusted Gross Income

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