What is House Hacking? – A Beginners Guide

“90% of all millionaires become so through owning Real Estate” – Andrew Carnegie

If there is one expense most Americans struggle with, it is housing. Housing is the single largest expense, taking up almost a third of our annual income. According to a survey for 2017, Americans spend an average of $19,884 on housing alone every single year.

For those of us who are pursuing financial independence, housing costs in terms of rent or mortgage payments are the biggest obstacles. While you can stop going out to eat or cancel your gym membership, your biggest savings can be made once you find ways to cut out your housing costs. Just by minimizing your housing expenses, you could cut your annual expenses by a third, helping you reach your financial goal considerably faster.

House Hacking is one of the best ways to get started in real estate investing. You purchase a multi-family property, live in one unit and rent out the rest. If you do the numbers right, your renters basically pay off your mortgage payment and you get to live for free.

Do I have your attention?

Let’s not waste any more time and get straight to it.

What is House Hacking?

The process of house hacking goes as follows: buy a property, preferably multi-family such as a duplex, triplex or fourplex, live in one unit and rent out the rest.

Ideally, the tenants pay enough in rent to cover the mortgage and other expenses, and you live for free.

Then once you move out and rent that unit, it could be great cash flowing investment property.

House hacking is a great way to get started with real estate investing. If you start with house hacking instead of choosing the conventional choices of renting or buying a house, you could build much more wealth over the years and ultimately reach your financial freedom sooner.

What are the Benefits of House Hacking?

We already talked about the first big benefit of House Hacking i.e. it helps to reduce or eliminate your housing costs. Also, if you continue to do it long enough, you ultimately get a paid off house. 

House Hacking and investing in rental property, in general, has a plethora of other fantastic benefits.

1. Residential Housing is Evergreen

As our world continues to rapidly advance, it has become harder to decide on a business model that is going to stick around for a while.

With brick and mortar retail stores disappearing at an alarming rate and robocars almost on their way to taking over the cab business, it can be quite intimidating to think about jumping into any type of business.

When in doubt, I go back to the basics of human necessity: food, shelter, and clothing.

These needs are irreplaceable. No matter how technologically advanced we get in the future, we will always continue to need these.

While technology has definitely made it easier to find houses to rent and own, the base concept of housing has not changed over the years.

2. Power of Leverage

Leverage, in finance, is an investment strategy that utilizes borrowing money from financial institutions to increase the potential return on investment.

The concept of Leverage can be better explained by doing some simple math.

Let’s say if you invest $100,000 in stocks and receive a return of 10% after one year, your profit will be $10,000 and return on investment or ROI 10%.

Profit = Current Value of Investment – Cost of Investment

= $110,000 – $100,000 = $10,000

ROI = Profit / Total amount paid out of pocket

= $10,000 / $100,000 = 0.1 or 10%

Now let’s say you choose to invest in some real estate that is worth $500,000, you pay 20% ($100,000) as a down payment, and fund the rest with a mortgage loan. Considering the property appreciates by 10% after one year, here’s how the numbers would look.

Profit = Current Value of Investment – Cost of Investment

= $550,000 – $500,000 = $50,000

ROI = Profit / Total amount paid out of pocket

= $50,000 / $100,000 = 0.5 or 50%!

Note that the appreciation here is received on the total property value, and not just what you paid out of pocket.

Even though the out of pocket amount and % return is the same in both types of investments, there is such a drastic difference in the profit and ROI.

That’s the power of leverage!

3. Cash Flow increases when rent goes up, but mortgage payment remains the same

Cash Flow is the additional income that is accumulated each month after paying the mortgage and other expenses.

Considering you took a fixed rate mortgage, the monthly payment will stay the same over the period of the loan term.

However, the rent will increase over time due to inflation, generating higher cash flow.

4. Lower interest rates than Investment Financing

When you’re looking to purchase a multi-family property (2-4 units), there are 2 types of loans that you can get – Owner Occupied Financing and Investment Financing. House hacking utilizes Owner Occupied Financing.

Owner Occupied Financing always gets better terms, as it’s considered a safer bet due to the fact that the owner is living in and overseeing the property.

Interest rates on owner-occupied mortgages tend to run an average of 1% to 1.5% lower than comparable investment property loans.

The best part is that once you move out later in the future, you still continue to receive the same terms of owner-occupied financing.

5. Lower down payment requirements

You also get the flexibility to put down less down payment when you’re financing owner-occupied.

Nowadays, if you’re looking to get Investment Financing, you are pretty much required to pay at least 25%.

However, the requirements for Owner Occupied Financing is much less stringent. You can get an owner-occupied loan by putting down as little as 3.5% for FHA loan or 3% for a conventional loan.

6. Learn how to be a landlord

Getting into real estate investing could be daunting, as it is more of a real business than just a “hands-off” investing, such as stocks or bonds.

This also means that if you’re really good at it, you could be making way more money than someone who doesn’t want to get their hands dirty. The best way to know your business is to actually run it yourself.

When you wear the “landlord” hat, you get valuable landlording experience with relatively low risk. This includes advertising your property, tenant screening and management, understanding rental agreement and contracts, dealing with unexpected repairs, negotiating with contractors and bookkeeping.

This way, when you move up to be a more “hands-off” real estate investor, you still hold valuable knowledge pertaining to the nitty-gritty of the real estate world. 

7. Tax Benefits

This one is big and one of the main reasons why investors love real estate so much!

Real estate investors get a number of tax benefits that help you cover the costs of home ownership and maintenance. I will cover all the tax benefits in another article, but here are the important ones.

i. Depreciation

Depreciation is a rental property tax deduction for the hypothetical wear and tear on your property. Even though you may not incur any costs to cover actual maintenance of your property, this rule allows you to take advantage as if your house is depreciating in value.

Generally, you can depreciate your rental property value minus the cost of land evenly over 27.5 years.

For example, let’s consider the total value of your property is $400,000 and the cost of land is $150,000.

This means the value of the building itself is $400,000 – $150,000 = $250,000

Now if you divide this value by 27.5, that’s the annual amount that you can deduct when filing your rental property taxes. You will do this each year to assess the current value of your property and the associated annual depreciation.

In this case, it is $250,000 / 27.5 = $9,091 depreciation per year.

ii. Equipment and Updates

Any equipment, such as a computer or automobile, as well as improvements to the property that adds to its value or extends its life, are tax deductible through depreciation as well. This could include putting on a new roof, updating the electrical system and plumbing, or adding new appliances.

To qualify for these expenses, the equipment and updates must be expected to last for over a year, increase value to your rental business, and depreciate over time.

iii. Mortgage Interest

Most people buy real estate by taking a mortgage loan. There are two components that make up your monthly mortgage payments: principal and interest. 

The interest component of your monthly mortgage payment is tax deductible, while the principal portion is not. These components are clearly mentioned in your monthly statement. Simply multiply the monthly amount by 12 to get the total annual interest.

iv. Defer capital gain taxes on sale using 1031 exchange

The IRS code’s Section 1031 allows you to defer taxes on the capital gains made from the sale of your investment property as long as another, “like kind” property is bought with the profit from the sale of investment property. 

The new property must be identified within 45 days and the deal must be closed within 180 days after the sale of the old property. 

v. Maintenance and Repairs

While home improvement is deductible through depreciation, you can also deduct certain maintenance and repairs separately.

The main difference is that these efforts keep your property in rentable condition without adding significant value. It could be painting, cleaning carpet/flooring, spraying for pests, landscaping, etc.

Any amount spent on contractors to do these repairs are also tax deductible. If you choose to do it yourself, you can deduct any equipment that you rented.

Property management fees, HOA and condo fees are also deductible using this tax code.

The list doesn’t stop here. There are a number of other expenses that are tax-deductible, such as insurance premiums, legal and professional fees, travel and transportation, office space, any utilities that you pay, such as electricity, water, garbage, internet, just to name a few. 

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Why don’t more people House Hack?

If there are endless benefits to house hacking, why don’t more people do it?

Although the concept of house hacking may sound simple, the actual execution can be far from it. Here are some of the biggest struggles that one can face when getting into house hacking.

1. House Hacking can be difficult in expensive markets

House hacking can be harder to accomplish in certain places due to sky-high property prices. This is particularly true in cities on the west coast, such as San Francisco, Seattle, Los Angeles, and San Diego. 

However, this shouldn’t stop you from house hacking, as there are many creative ways to house hack in expensive cities. Also, if you don’t mind commuting, you can usually find properties further away in areas that are much more affordable. 

2. Sharing with tenants

House hacking may require some level of sacrifice of your personal lifestyle. In this new home, you will be sharing the property, common spaces and/or utilities with other tenants.

There are certain advantages in doing so. You will save a ton of money if you are sharing common expenses such as landscaping, exterior lighting, water, sewer, and garbage.

In addition, remember that you are not just another tenant living in this apartment, you own this apartment. You get to set the rules and expectations for your tenants. 

3. Lower quality of living

The quality of living experience may not be comparable to the amount of money spent on the property. 

For instance, you will be spending more money to purchase a multi-family home compared to a single-family home, yet you still have to live in an apartment set up rather than in a house of your own. 

With this said, you will be spending considerably less money by house hacking. While you are having to compromise on your living situation, you now have extra money that gives you the option to improve other areas of your life. 

4. Best deals are not pretty

Most often you won’t find a stellar property that will start cash flowing right away. The best deals are often not the prettiest. 

In fact, I would specifically stay away from stellar properties as they don’t provide any further growth potential, will likely be more expensive, and tend to have more competition.

5. Working with contractors

Considering the property isn’t rent ready, you will have to work with contractors on a regular basis to renovate it and get it’s condition up to the current standard of the area. A lot of people go overboard on this, spending a lot more on unnecessary upgrades that do not really produce additional rent.

6. Property management can be tedious

Finally, rental property is not just an investment, it’s a business. 

Your responsibilities will include posting ads for vacant units, screening your tenants, maintaining lease documents, handling maintenance requests, and if necessary, handing out evictions.

If you are overwhelmed with these tasks, you can always hire a property management company to do these for you.

Why shouldn’t you House Hack a 5 or more unit property?

Though you surely can House Hack a 5 or more unit property, I’d advise against it. Here are my reasons behind why I think you should stick to 2-4 unit properties for house hacking.

1. Less financing options

Properties with 5 or more units require Commercial financing, compared to the Residential financing required by 4 or fewer unit properties. Most banks do not participate in commercial financing, giving you considerably fewer options to shop around for the best available rates.

2. Stringent requirements

Commercial Financing focuses mostly on the experience level of the borrower in the type of real estate being financed, and the financials of the building.

The borrower is required to provide complex tax returns, complete REO schedules, and extra details for every home underwritten and approved. Also, the minimum credit score required is 720.

3. Higher down payment

With Commercial Financing, you’re looking at a much higher minimum down payment, typically 25% or more. In contrast, you can get a residential property financed for as low as 3% down payment.

4. Shorter and more complicated terms

Unlike residential loans, the terms of commercial loans typically range from five years to 20 years, and the amortization period is often longer than the term of the loan.

For example, your loan term could be 7 years with an amortization period of 30 years. In this case, you’ll be making payments for 7 years with the amount based on the loan being paid off over 30 years, followed by one final “balloon” payment to pay off the remainder of the loan amount.

All these restrictions make it very difficult for new investors to get financed for commercial properties with 5 or more units.

Can I House Hack a Single Family Home?

Since the whole point of House Hacking is to live in one unit and rent out the rest, the minimum number of units that we should be looking for is a 2-unit Duplex.

However, If you already own a single family residence, there’s no need to be discouraged. You can still House Hack by renting out any spare room or even convert your basement into an additional unit. You can also get creative by converting any unused spaces, like a garage into bedrooms, and renting them out to long term tenants or short term Airbnb rentals.

It ultimately comes down to how much of your lifestyle you are willing to sacrifice. If you do not mind sharing common spaces, such as the kitchen and bathroom, this strategy could save you thousands of dollars every year.

I know people who have taken House Hacking to whole new levels. Some go as far as to live in an RV parked in their backyard and rent out the entire house. Check out Airbnb to find out creative ways that people house hack.

Depending on where you live, the difficulty in being able to House Hack will vary. But if you’re really committed to it, you’ll be able to do it anywhere.

A Final Note

If you are looking to break into real estate investing but do not want to take on the burden of paying mortgage payments for decades to come, House Hacking could be the perfect strategy for you.

House hacking sits in a sweet spot and gives you the best of both worlds- you get the best financing terms like a conventional home purchase, and infinite tax benefits on your rental income and capital gains like its an investment property.

There are many ways to make money in real estate, but House hacking might be the safest, steadiest and simplest way to do so.

I hope this guide has been helpful and informative. The ball is now in your court. The only way to get it rolling is to get out there and start looking at properties yourself. 

In the next article, I will break down this process into simple and tangible steps that you can take to successfully house hack your first property. Stay tuned.

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