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Last Updated : July 5, 2024

House Hacking | Tax Benefits for Real Estate Investors

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This episode of the Tax Smart REI Podcast features Alex Savage, a senior tax adviser who has successfully leveraged house hacking to maximize tax savings and bolster his investment portfolio.

House hacking is a real estate investment strategy that involves purchasing a property with multiple units and residing in one unit while renting out the others. This approach can significantly offset or even completely cover your mortgage and operational costs through rental income.

Alex began his career in a mid-sized accounting firm, primarily serving local real estate investors. Observing that many successful clients paid minimal taxes through strategic investments sparked his interest in real estate. He debunked the common misconception that starting in real estate requires substantial capital, sharing how he entered the market with limited funds and a strategic approach.

Key Takeaways from Alex’s Experience

  • Financial Leverage: Alex’s first house hacking venture involved a duplex where he lived in one unit and rented out the other. This arrangement allowed him to drastically reduce his living expenses and accumulate savings for further investments.
  • Tax Benefits: Through house hacking, Alex utilized various tax strategies, including depreciation and claiming deductions for expenses related to the rented unit. He also highlighted the potential to avoid capital gains tax on the sale of the property under certain conditions, thanks to the Section 121 Exclusion.
  • Educational Growth: Alex stressed the importance of self-education in real estate. He recommended resources like BiggerPockets, books, and webinars that helped him build a solid foundation in real estate investing.

The Role of Bookkeeping in House Hacking

Effective bookkeeping is crucial in managing the financial aspects of house hacking. Alex emphasized the need to maintain separate accounts for personal and rental property finances to streamline tax preparation and ensure accuracy in financial reporting. He shared how setting up a dedicated bank account for the rental unit made it easier to track income and expenses, which is beneficial for both tax purposes and financial management.

  • Clear Financial Tracking: By using a separate account for rental activities, all transactions related to the property can be easily identified, simplifying the process of claiming deductions and preparing financial statements.
  • Simplified Tax Filing: With organized records, tax filing becomes less cumbersome, reducing the likelihood of errors and the stress associated with tax season.
  • Audit Readiness: Should the IRS query your tax filings, having well-organized financial records can help substantiate your claims, making audits less daunting.

Understanding Partial Asset Dispositions in Real Estate

During our discussion, Alex also touched on the concept of partial asset dispositions, a critical aspect often overlooked in real estate accounting. This approach allows property owners to claim a loss on the disposal of part of a property (like an old roof or HVAC unit) when it is replaced, rather than continuing to depreciate something that’s no longer in use. Alex explained how leveraging partial asset dispositions can optimize tax benefits by allowing investors to recognize a loss on the disposition of the old asset, which can offset gains elsewhere.

Navigating Challenges and Misconceptions

House hacking comes with its unique set of challenges and misconceptions. Alex and Ryan discussed the importance of being prepared for the realities of being both a homeowner and a landlord. This includes managing tenant relationships, handling maintenance issues, and understanding the financial implications of real estate investments.

Conclusion: Is House Hacking Right for You?

House hacking is a compelling strategy for both novice and seasoned investors. It offers a practical entry point into real estate investing, significant financial benefits, and valuable hands-on experience in property management. Whether you are looking to start your investment journey or seeking ways to reduce your living expenses while expanding your portfolio, house hacking might be the perfect strategy.

Want to know if house hacking is the tax strategy for you? Contact us today. Continue reading for this episode’s transcript.

Transcript

Introduction

Ryan: Hey, thanks for tuning in to this week’s episode of the Taxmart REI Podcast. Tom is out for the next few weeks, but we have a lineup of surprise guests and co-hosts in his absence. To discuss various tax topics, on our show today, I’m joined by Alex Savage, who is a senior tax adviser at our firm. We break down the best practices of house hacking, along with some common misconceptions and how to maximize tax savings when selling the property using a combination of strategies and more. If you’re currently house hacking or interested in house hacking and want to maximize your tax deductions, this is a must-listen-to episode for you. We’ll be diving into all that in just one minute.

Ryan: Hey Alex, thank you for joining us today. Would you mind giving our listeners a little bit of information about you?

About Alex

Alex: Yeah, absolutely. Thanks for having me, Ryan. Appreciate it. So, I grew up in Des Moines, Iowa, and I’m currently located in St. George, Utah. I’ll tell you a little bit about how we got here in a second. I played basketball at a D3 school in small-town Iowa where I met my wife. We recently got married about seven months ago, and that same month, we moved down here to St. George to get outdoors a little bit and explore and see some of the world. It’s a different part of the world; I’ve been in Iowa all my life.

I started out in a midsize accounting firm where we served a lot of local real estate investors, and I started to realize that these wealthy people paid little to no tax. That really got the gears going for me and sparked my passion for real estate investing. I did have a misconception starting out that you need a lot of money to get started, and that’s certainly not the case. It took me a couple of years of research to figure out why that is, how that is, and what strategies to use if you don’t have a lot of resources, being a young 20-year-old kid out of college.

Getting Started in Real Estate

From there, I think like most real estate investors, I found BiggerPockets. I dove into their podcasts, books, and webinars hosted by Brandon Turner, and that really got me down the rabbit hole of house hacking. It took me about two years from there to really pursue that first deal for real, but that’s a little bit of my journey and how I got started in house hacking and a little bit about my background.

Ryan: Yeah, I know a lot of people get started with house hacking, and I feel like that’s a new phrase, but it’s not a new idea or concept. People have been doing this for a long time, but I think BiggerPockets made it popular for sure as they talked about it on their podcast and things. I totally agree; it’s a great way to get started, especially when you’re young and looking to get into real estate. You like real estate as an asset class for yourself, and we all need a place to live, right? So why not get some of that help from tenants and so forth to help pay for some of that rent cost?

Alex: Absolutely.

Alex’s First House Hack

Ryan: As we get started talking about this, I think it would be good to start with your first deal. How you got into that, give us the details of that, and we’ll take questions off of that.

Alex: Yeah, no, it’s perfect. So, I completed two house hack deals in the Des Moines area, different parts of town, but I’ll get into those here in a second. What really happened was it was a springboard for me to get out of student loan debt, create a nice emergency fund, and start building out an investment portfolio. For me, that was a lot in the stock market, but it could be just keep building real estate, could be whatever you want it to be. Once you’re out of student loan debt and have some cash, you’re okay.

The sky’s the limit, and you can go do what you want to do. House hacking was that springboard for me to keep my housing cost low and allow that cash flow to free up. I wouldn’t trade any of those investments for anything; I would do them again in a heartbeat. However, I don’t know if more house hacks are in my future. Let’s put it that way. I don’t know if my wife would appreciate it. I’ll dive into my first deal.

Funding the Deal

So, like I said, my misconception was that you need a lot of money to get started, and then from there, it’s all good. But what happened was I was actually able to connect with a local credit union, and they financed it 100%. It was a conventional mortgage, a 30-year. So, what happened was 80% of it was a conventional 30-year mortgage, and 20%, which is typically your down payment, was a 10-year ARM. After 10 years, that rate would adjust, but the rate was just slightly higher than the conventional 30-year. They 100% financed my first deal. I used an IRA exemption for a first-time home buyer, so I did have to fund the closing cost, which was about $3,000 to $4,000. I was able to pull that out of my IRA to keep my cash. I’m conservative, right? A CPA, so I like to keep my cash. I pulled that out of my IRA for the closing cost, about $3,000 to $4,000.

That was able to fund my first deal with $3,000 to $4,000 out of pocket. Pretty minimal cost, I would argue. I bought that one for $200,000, and the closing date was 3/31/2020, right when COVID was becoming serious here in the United States. I did have a little freakout period where I was talking to lawyers, asking if I could get out of this thing. Thankfully, they talked me into keeping it, saying, “Hey man, real estate’s real estate; you’re going to want to do the deal.” Thankfully, I did go ahead and do the deal.

Mortgage Breakdown

My total mortgage with taxes, insurance, and everything was about $1,200, and I had about a 3.8% mortgage rate because it was my primary residence. The rent coming in was $750 from the bottom unit, and the top unit was where I was going to move in. Out of pocket per month, I paid about $450 to $500 every month, so super low housing cost. Before that, I was renting for about $1,400 in another apartment, so it was a big change for me and a big savings. On top of that, I was able to own a real estate house.

Ryan: Yeah, you’ve got appreciation over those years. I know we’re going to get into selling a property and so forth. You’ve got depreciation, which we’ll also talk about, debt paydown help from renters, and cash flow there. If you compare the difference between what you would have paid in rent to what you’re actually having to pay, that’s great, man. Yeah, and I was just going to chime in here and say, while you were talking, I was looking up my closing statement for a duplex that we did the same thing, kind of a house hack. Our closing statement was March 3, 2020, so that was right around that time.

What it Looks Like for You

Alex: Totally. Did you have any reservations, or were you cooler than I was?

Ryan: At the time, I had my wife buying this with me, so I had to get her input on this, like do we move forward? We ended up doing it, and maybe I’ll tie in some of my experience too, but yeah, continue on with what you’ve got going on.

Alex: No, that’s awesome. So, $750 in rent was coming in, and it was well under the market. I could have probably gotten it up to closer to a grand if I had booted them out, but it is a different dynamic. When you’re literally living right above the tenant, you’re more connected to them on a personal level than if you were managing it from afar or had a property manager. I was able to increase it by 3% per year every time their lease was renewed, but I kept it low. It felt like the right thing to do. It was a somewhat rundown neighborhood, and pushing it to market would have forced them to leave and find a new home. I didn’t want that. There is a different dynamic when you’re house hacking, living right next to your tenant. It has its benefits and its downsides if you’re not ready for that.

Increasing Rent

Ryan: I’m curious too, how did you get the 3% increase? I’ve seen that more common in commercial, but just in residential, was that already in a lease that you had? Did you work with your brother-in-law to help you with that? How did you do that?

Alex: That’s a great question. I was a complete newbie who didn’t even know that was standard. I had heard like two to 3%, but it was really just what I thought they could afford. If I went higher, it would have probably pushed them out, but it kept me satisfied and kept them happy. That’s really where I landed on it. It wasn’t anything special or written into the lease. It was just what worked for both of us.

Ryan: Awesome. Anything else with your first property you want to talk about? Otherwise, we can talk about your second one.

Gaining Traction in House Hacking

Alex: We can jump into the second one. The second one was about a year and a half later. This was getting into somewhat post-COVID where the market was getting really hot. My cousin and I had been looking for duplexes around this same area for quite a while, almost as I bought my first one. We couldn’t find anything that made sense numbers-wise. This one came on the market; I went and saw it that same day, and we made an offer that same night. They accepted it that night. They were in a hurry too. We moved fast, made this full-price offer, and everything worked out. They ended up paying closing costs. We did the same loan, so he needed a place to live. He definitely needed to move in. I moved in for a short amount of time, and he moved in for about a month and a half.

We were able to buy this with zero money down, the same loan, 100% financed, 80/20, and they paid all the closing costs and even made a couple of low repairs. It was insane. Literally zero money out of our pockets. The net rate was close to 3.2%. Rates were still going down at that time. It was a pretty incredible deal. We got it just by moving fast and knowing that area. We knew that’s where we wanted after scoping it out for over a year, and we went after it and pursued it, and it worked out.
Ryan: That’s awesome.

Structuring the Deals

Alex: This was me and my cousin. We bought this 50/50. We bought it for $325,000 at the end of 2021. He moved in for about a month and a half. We ran it by our lender multiple times to make sure it was okay to eventually rent it out. They were fine with that as long as we moved in. The empty unit was perfect for us. The other unit was being used as a short-term rental. The tenant wanted both units for short-term rental, so we agreed. We charged above-market rent, and it’s been a win-win for us.

Ryan: How did you and your cousin set that up? Did you do an LLC?

Alex: No, we didn’t set up an LLC. We have a TIC (tenancy in common) structure. We each report half the income and deductions. It’s easier and less complex, but rigid. We didn’t see a need for an LLC at the time.

Ryan: Just to highlight, an LLC doesn’t provide tax savings; it’s for liability protection. A TIC structure is very rigid, but it’s simpler and saves legal costs. You report everything 50/50. Anything else you want to add?

Alex: No, that pretty much covers it. I would just add that when you find tenants, make sure the lease terms allow flexibility for you to move in. Look for month-to-month leases or empty units.

Ryan: Absolutely. Keeping separate bank accounts is good practice. It simplifies bookkeeping and makes tax time easier. You don’t have to, but it sets you up for success. Deductible expenses are related to the rental property. Separate personal and business expenses. Anything else to add?

Alex: No, you summed it up well.

Cost Segregation Studies & Depreciation Recapture

Ryan: Great. Did you do a cost segregation study on one or both properties?

Alex: Yes, I did on both. I took advantage of the passive activity loss allowance. The cost segregation study allowed me to take a loss against my W2 income, which was significant. I was under the income limit at the time.

Ryan: That’s great. Selling the property, did you face recapture?

Alex: Yes, I did. The depreciation recapture was taxed at ordinary income rates, and the capital gain was taxed at capital gains rates. I sold it after about two and a half years. Half of the gain was excluded under the home sale exclusion.

Advice for House Hacking

Ryan: Good to know. If you’re going to sell, keep in mind the two out of the last five years rule. Any final advice for house hacking?

Alex: Be specific and patient with your search. Get familiar with your finances, and be prepared for anything. House hacking is a great way to build wealth, especially if you’re young. It’s important to find the right property and know what you can handle financially.

Ryan: Great advice. Thanks, Alex. If you’re looking for an advisor or considering a career shift, reach out to us. Thanks for joining me today, Alex. We’ll talk with you and everyone else next time.

Alex: Sounds great. Thanks, Ryan.