House Hacking – How to Transform Your Home into a Profitable Investment

House hacking has gained popularity in recent years as a means for people to build wealth.  Additionally, it’s become a back door for first time home buyers priced out of the market by traditional home ownership. In this article, we explore house hacking and the share the success stories of two house hackers.

Understanding House Hacking

House hacking involves turning your primary residence into a source of income by renting out a portion of it. It has become especially popular due to the Financial Independence, Retire Early (F.I.R.E. ) movement.  Young people are increasingly finding homes unaffordable and are looking at strategies for home ownership.  Others use the strategy for building financial independence.

Greg Gaudet house hacked in the high priced market of Maui, where the median home price is over $1.2 million.  Gaudet says “House hacking was the single biggest tool that we used to take ourselves from living paycheck to paycheck, to being able to only work part time and still have extra money left each month!”

Common forms of house hacking are renting out a spare room, a basement, or even a separate unit on the property. The goal is to offset your housing expenses or turn a profit. It’s a practical approach to home ownership that requires careful consideration and planning.

Choosing the Right Property

The success of house hacking starts with choosing the right property. Deni Supplee, founder of Spark Rental, says “I begin looking for ideal spaces that would make great rental or income possibilities. It doesn’t always have to be a duplex or small multi-unit. Homes with in-law suites, or large garages or outbuildings can serve very well for house-hacking and bringing in extra money. ”  Supplee says she even, “rented out a garage we had on a property. I had none of the hassles of dealing with a residential tenant and still brought in steady monthly income”.

Not every house hack looks the same.  In fact, the opportunities are as vast as your creativity.  I have a friend who owns rentals in a college town.  His technique is to rent out rooms to other college students.  He intentionally buys homes with extra space such as oversized bedrooms or living rooms and adds walls t to increase the number of bedrooms.  He then rents out the new bedrooms.  Supplee, did something similar with a property with multiple bedrooms.  She joined a student exchange program.  Her efforts resulted in a student from China paying half of Supplee’s mortgage for 4 years!

Financing Your House Hack

Financing a house hack involves unique considerations. FHA loans, for example, allow for low down payments, making it easier to enter the real estate market. FHA loans often require only 3% down.  However, not every home will qualify for an FHA loan. Conventional loans are another option but often require a larger down payment, typically 5% to 20% down.  If you are considering buying a home to hack, take the time to speak to your mortgage lender.  Ask your lender what the financing options are that align with your goals and financial situation.

Legal Considerations

Many municipalities have enacted strict rules to restrict rentals and require permits.  Many have restrictions on the number of unrelated individuals living together or renting out spaces within a home.  Before diving in, house hackers should familiarize themselves with local zoning laws and regulations.

Supplee says “Legal issues are not ones you want to deal with. They can become very expensive”.  Even before renting out a room in your home, she suggests checking with local codes. She adds, “Many cities and local area have even banned them. If they are not banned, there are all kinds of extra taxes and business registration fees.”

Gaudet admits that he found this out the hard way.  He built a custom AirBnB.  For the first year, rents covered half of his $3,000 mortgage.  However, he didn’t have a permit for the AirBnB.  Gaudet says “we were shut down pretty quickly. After we were shut down I attempted to see if we could get the permit, but quickly learned that there was no way.”  After speaking with the City, Gaudet found that he could not get a permit for short term rental use until he owned the property for 5 years.

That didn’t stop Gaudet.  He refinanced the home and used the money to build a detached Accessory Dwelling Unit(ADU) on the same property.  He then rented out the ADU and his rents covered the monthly mortgage on the primary residence.

Managing Tenants

Being a landlord comes with responsibilities. When house hacking, you become both homeowner and property manager. The best advice for managing tenants, “is not to have to” says Supplee. Make sure you do your due diligence, and require “full rental application and credit checks. Contact prior landlords. And frankly, as soon as any issue erupts, send a notice, and stay on top of it as soon as it happens.”

Handling the Challenges

House hacking isn’t without challenges. Living in close proximity to tenants can lead to conflicts, and property management requires time and effort. Additionally, market fluctuations can impact property values and rental income. Having contingency plans and being prepared for challenges will contribute to the long-term success of your house hacking venture.

Supplee suggests, “Have policies in effect and keep to them.”    In addition, have all of your policies written and be consistent in carrying them out.  Tenants often communicate with each other and will challenge you over inconsistent policies.  Lastly, “Have a team always on standby.” says Supplee, “This means legal, maintenance and management. Do not wait for a large repair issue to look for contractors. Interview and have a list of them on hand.”

Maximizing Tax Benefits

Understanding the tax implications of house hacking is essential. Certain expenses related to your rental activities may be tax-deductible.  Mortgage interest, property taxes, and maintenance costs are typically tax deductible for rental properties.

It’s important to know what you can fully deduct on your taxes, versus what must be depreciated over time.  Make the effort to learn the difference between capitalized and depreciation expenses.  While depreciation can be a hidden benefit, it comes with a hefty recapture tax (25%) upon the sale of your rental properties.  Knowing which expenses you can capitalize instead of depreciating can save you several thousand of dollars in taxes.

If you are renting out space or have an office in your home, there are allowances for the business use of your home.  However, carefully consider the tax consequences that you may incur when you finally sell you home.  Business use of the home deductions are also subject to recapture taxes.

Lastly, be sure to keep organized and detailed records for tax purposes.  It will make your tax planning much easier.

Evaluating Long-Term Goals

House hacking can be a stepping stone to achieving broader financial goals. For Gaudet, his long term goal is to “create long term wealth by saving our monthly income rather than using it to pay our mortgage”.  Instead, he’s investing that money into savings in order to provide financial independence for his family.

Before starting to house hack, consider your long-term objectives.  Is it to accumulate real estate assets, building equity, or transitioning to a different investment strategy? Whatever your strategy is, it should reflect your long term goals.  Lastly, it’s beneficial to regularly evaluate the performance of your house hack in relation to your financial goals and adjust your strategy as needed.

Conclusion

House hacking can be a means to both build wealth and an opportunity for buyers who would otherwise be unable to afford a home. However, it does come with potential problems.  From choosing the right property to navigating legal considerations and managing tenants, each aspect requires careful attention. Remember, if you choose to house hack, you’re making long term decision and do your due diligence.