Welcome to the House Hacking podcast!
In this episode, we will take a deep dive into the taxes and accounting factors that you should consider when house hacking. We will cover the tax strategies to help you on your real estate journey with today’s guest, Amanda Han. Amanda is a successful real estate investor, BiggerPockets contributor, CPA, and author who shares her wealth of knowledge with us.
Making a tax mistake with your real estate portfolio could cost you big time. Learn how to avoid other expensive real estate mistakes with our free guide.
What are the benefits of using a CPA?
It can be tempting to use free software to complete your taxes. But there are many benefits of working with a CPA. Although not everyone needs to work with a CPA, real estate investors are likely to gain from using a CPA.
That’s because the tax code is filled with many loopholes and benefits specifically designed for real estate investors. If you don’t want to spend hours pouring over the tax code as a real estate investor, then you can likely uncover substantial value from choosing to hire a CPA. Although you can do some research yourself, the intricacies of the tax code benefits for real estate investors likely require the expert knowledge of a CPA specializing in real estate.
You might not want to spend the money on a CPA. But an efficient CPA is well worth the cost. Instead of tripping over dollars to pick up pennies, you can capitalize on the specialized knowledge of a CPA to potentially lower your overall tax burden. With their help, you can potentially legally lower your taxes.
What to look for in a CPA
As a real estate investor, your CPA’s most important quality is that they are well-versed in real estate. Since real estate will be one of your largest wealth-building classes, it is critical that your CPA is trained on the subject.
The tax code is vast and complicated. With that, you don’t want a jack of all trades that is willing to help you with taxes of any kind. Instead, you want a CPA that has specialized in real estate.
If you aren’t sure whether or not a CPA is a good fit for you, then throw out some questions, including:
- Real estate terms. You might mention that you are doing a house hack or considering depreciation. If they are confused by the concept, then you likely want to move on. You shouldn’t need to explain real estate investing strategies to the CPA that you decide on.
- Other clients. Another question to ask a potential CPA is what strategies they have seen other clients try that lead to a successful outcome. If they don’t have any real estate clients that come to mind, you should look elsewhere. You don’t want to be the CPA’s only real estate client.
- CPA or tax preparer. While anyone can be a tax preparer, Certified Public Accounts (CPAs) are trained on accounting topics. With that, they are better prepared to offer insight into your tax liabilities. If you cannot find a CPA, then a tax enrolled agent is a good option because they receive some IRS training before preparing your taxes.
As you seek out a great CPA, don’t be afraid to look beyond your local area. There may be great CPAs that are willing to work with you via video and phone calls. However, it is okay if you are more comfortable with an in-person CPA.
How to track metrics throughout the year
When it is time to work with your CPA, they will need quite a bit of information from you about your financial situation. Even if you find the best CPA available, you need to stay organized and track all expenses throughout the year. Otherwise, they will not be able to help you in a big way.
Throughout the year, you need to track all tax-deductible expenses. If you can do this in real-time, you are more likely to stay organized. That makes tax time easy!
To track these things, you can create a system that works for you. A few good options include Quicken, Google Docs, receipt scanning software, or a well-organized filing cabinet. Use whatever system makes the most sense for your needs.
How long do I need to save receipts?
Let’s say you made a repair at an investment property that required $100 in supplies from Home Depot. If you are tracking your expenses in a system and using a credit card to pay for this expense, do you need to save your receipt?
Although the funds can be seen on your credit card statement, keeping the receipt is a good insurance policy. If you have a receipt from a repair at an investment property, it is a good idea to save it. You can keep the physical paper or scan a copy to keep it digitally.
In most cases, you’ll never need the receipt again. But if you are audited and the expense is questioned, then the receipt can prove that you bought supplies to repair your investment property.
For small regular expenses, you should keep a copy of the receipt for at least three years from the date that you file your taxes. However, you should hold on to certain documents for longer including closing disclosures, loan documents, receipts for major repairs on your house hack.
What expenses should you be tracking
Beyond the more obvious direct expenses which include things such as repairs and renovations, you should track overhead expenses. Not sure what expenses you should be tracking? Amanda shares her suggestions below:
- Educational materials. If you bought a book to help you learn more about your real estate business, that should be recorded.
- Accounting and legal fees. You should track the fees that you pay to these professionals.
- Car expenses. You should track the mileage and gas spent driving to properties or local real estate meetings.
- Home office expenses. If you work out of your home office, then you should track the costs of maintaining the office. You are able to deduct a portion of the household expenses such as cleaning fees, internet, security, and more.
As a house hacker, it is easy to overlook these expenses. However, it can be very valuable to track.
Here’s an example to illustrate the importance of tracking your indirect expenses. Let’s say that you are a house hacking in a three-bedroom home. You’ve rented out one room, live in one room, and use the third as an office space. The rental room and home office would claim two separate deductions for the rental business side of things.
Thank you to everyone that took a minute to ask a question. Here are the answers you asked for!
How should I strategize about making improvements to the owner-occupied unit?
Let's say the owner lives on one side of a duplex and would like to upgrade the bathroom. They want to know if they would miss out on the tax benefits by completing the update while living in the unit.
Luckily, you won’t lose out on the tax deduction for upgrading the bathroom. You cannot take the deduction immediately. But the money you spent on the remodel goes into the cost basis for the property. When you move out of the unit and rent it, you’ll be able to depreciate it. With that, you can still enjoy the new bathroom while you are living in the unit.
But if you simply want to maximize your deduction instead of enjoying a new bathroom, then you should wait until after you convert the property into a rental. If you do the renovation in the same year that you turn it into a rental, additional tax strategies can be explored.
What is the difference between repairs and improvements?
Generally, if you are remodeling an entire area that would be considered an improvement. For example, if you are remodeling the whole bathroom that is usually an improvement. If you are doing a one-off fix, that is typically a repair. For example, if you replace a leaky toilet that would be considered a repair.
A repair can be written off immediately. An improvement will need to be depreciated.
What do you wish you knew when you started that you know now?
She wishes that she had started earlier. It was scary to get started, but it was the right decision for them.
Are there advantages or disadvantages of using an LLC for a house hack?
One of the benefits of house hacking is that you can use attractive owner financing options such as VA, USDA, or FHA loans. These loans can allow you to put very little down with a great interest rate. When you buy a home through an LLC, you’ll be required to put down 20% or more to purchase the property.
From a tax perspective, there is not a legal need to purchase your house hack under an LLC. You can take advantage of real estate tax deductions whether you hold the properties personally or through an LLC.
How does the 250/500 tax-free benefit work? Or does it change at all if your house hacking?
The tax-free benefit provided by the federal government is that you can exclude up to $250,000 gain on your primary residence if you’ve lived there for two out of the most recent five years. If you are married, then you can exclude the first $500,000 of gain from your taxes.
This doesn’t change if you are house hacking a single-family home. If you are house hacking a multi-family property, then the tax exclusion may be prorated. If you are considering this tax-free opportunity, then you’ll need to sell the house within 3 years of moving out.
Can you clarify the capital gains rule?
Unlike stocks, which have a one-year time frame for the long-term capital gains distinction, real estate requires a longer holding period. In terms of the 250/500 rule, you’ll need to live in the property for at least 2 years to qualify.
But of course, there are exceptions. You might be able to prorate your gain if you had to move due to an unforeseen death, divorce, multiple births, healthcare issues, or job changes.
How does depreciation work with a house hack?
Depreciation can be considered in your taxes while house hacking. But how much should you include? If you are renting out rooms in your home, then you will likely use square footage as the measurement to determine how much is depreciable. If you have a multi-family property with clear divisions, then you can calculate depreciation based on the number of units rented.
Is income taxed differently for house hackers that rent out on a short-term basis vs. long-term unit basis?
It depends on the type of services you are offering for the rental.
If you are renting a spare room on Airbnb without offering additional services, you would be taxed the same as a long-term rental. If you provide cooking and other services like a traditional bed and breakfast, then you would be taxed differently. Since you are doing more than renting, then you’ll likely need to pay self-employment taxes.
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If you don’t win, then consider purchasing Amanda’s books. Both offer really amazing information. Check them out below:
- Tax Strategies for the Savvy Real Estate Investor
- The Book on Advanced Tax Strategies: Cracking the Code for Savvy Real Estate Investors
How to connect with Amanda
The famous six
What is your favorite personal finance blog, book, or podcast that you’ve read recently?
The Four Hour Work Week by Tim Ferris
What’s your favorite real estate related blog or book you’ve read recently?
What is your favorite travel destination so far?
Where will you travel next?
A cruise to Mexico
What is the biggest bucket list goal that you haven’t accomplished yet?
To live in another country for an entire month for an immersion vacation.
What is your favorite life hack?
A Roomba that vacuums and mops her floors for her!
Taxes are ever-changing
Thank you for being a part of our community!
Please keep in mind that this episode was recorded in Fall 2020. Tax laws change on a regular basis. With that, you may run into difficult tax complications if you are listening to this episode a few years from now. Please consult with a CPA about your unique situation before moving forward.