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House hacking, a popular strategy among new real estate investors, offers a way to live rent-free while tenants cover your mortgage. This involves buying a property and renting out unoccupied units or rooms. However, it's crucial to grasp the tax implications to avoid issues during potential audits due to underreporting rental income.
Foundations of Real Estate Taxation:
Before diving into real estate investing, grasp the basics of real estate taxation. Given that tax laws evolve annually, verify the deductibility of expenses each year. Consult a tax professional during tax preparation to ensure correct filing, potentially saving money by leveraging all eligible deductions.
Local, State, and Federal Tax Obligations:
Understand that house hacking may incur taxes at local, state, and federal levels. Property taxes, a common local tax, can be contested if the assessment is inaccurate. Federal taxes include income tax, capital gains tax on sales, and depreciation recapture tax.
Allocating Expenses:
Separate personal and business expenses for tax purposes. Determine the percentage of property occupied by you and tenants to calculate tax deductions accurately. For example, if you occupy 30% of a property, only 30% of insurance premiums may be personal expenses, while the rest qualifies as business-related.
Capital Gains and Sale of Property:
Selling a property triggers capital gains and depreciation recapture taxes. Understand these before selling to avoid surprises. Capital gains tax is levied on the profit from the sale, while depreciation recapture taxes the previously deducted depreciation.
Section 121 Exclusion:
Section 121 of the U.S. federal tax code allows homeowners to exclude some capital gains when selling. However, house hackers can only apply this exclusion to the part of the home they occupy, not the rented portion.
Tax Deductions for House Hackers:
Several expenses related to house hacking may be tax-deductible, including mortgage interest, property taxes, depreciation, repairs, furnishings, utilities, insurance premiums, advertising, and HOA fees. Keep accurate records to support these deductions.
Income Reporting and Recordkeeping:
Report income and expenses on IRS Schedule E, differentiating between personal and rental use. Maintain meticulous records, including rent receipts, repair receipts, asset purchases, and depreciation schedules.
Preparing Your Taxes:
Choose between preparing taxes independently, using software, or hiring a tax professional. While self-preparation is cost-effective, it may be time-consuming and prone to errors. Tax professionals ensure accurate filings, potentially uncovering additional legal deductions.
Final Considerations:
Given the ever-changing real estate tax landscape, staying informed is essential. Incorrect reporting could lead to audits and penalties. Consult a tax professional for clarity on deductions and expenses, making the fee a worthwhile investment compared to potential audit hassles.