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Since tax season is quickly coming upon us, I wanted to share a story of how I royally screwed up my taxes when I first graduated from college. This story isn’t to dissuade you from doing your own taxes. Instead, I hope this helps you avoid making some of the same mistakes that I made. If you are into house hacking, this should be especially helpful for you.
A Great Living Situation
When I first bought my house in June 2004, I rented out three rooms in my house. Not only did my housemates help pay down my massive mortgage payments, they also helped defray the monthly utility costs. It was a huge win/win for all parties involved. They received a lower-end market rate rent, and I had consistent, reliable renters in my home.
Up until I bought my house, my tax situation had been very straight-forward. The only things that I had to include were my W-2 forms and charitable contributions.
Mortgage Interest
When I started to prepare my taxes for 2005, as a homeowner, I thought I’d just have to include one more form- the mortgage interest. I followed along with the instructions provided by TurboTax and thought I was good to go. In reality, I didn’t completely understand my tax situation at the time.
At first, things seemed really simple as I filled out all the required information. However, in the end, I had accidentally included my mortgage interest twice.
That was a huge mistake. I had included the mortgage interest in two sections: in the Schedule A section under itemized deductions, and in the Schedule E section, under rental income. What I should have done is allocate a portion of the mortgage interest deduction towards the Schedule A and a portion towards the Schedule E.
Rental Properties
If you live in a property that you also rent out, the IRS says that you must either split the mortgage expenses on the Schedule A and E, based on the number of people living in the property, or by the square footage that the person has access to.
So in layman’s terms, if you have a condo with a mortgage and rent it out to a roommate who has access to the whole condo, you would theoretically split the mortgage in half: half of the mortgage interest would be applied to the Schedule A, and the other half towards the Schedule E. So, if you pay $12,000 in mortgage interest, you would apply $6,000 towards your Schedule A and $6,000 towards Schedule E.
On the flip side, let’s say that you have a 3,000 square foot house and lease out the basement to someone. Let’s also say that the basement is 750 square feet and the renter has no access to any other part of your house. In this case you may consider opting to split your mortgage costs by square footage. In this case, you would apply 75% of your mortgage interest towards your Schedule A and the remaining 25% towards your Schedule E. That would mean that if you had $12,000 in mortgage interest, then you would apply $9,000 (75%) towards your Schedule A and $3,000 (25%) towards your Schedule E.
Now that you know the rule, I’ll share the rest of the story.
Massive Tax Refunds
I reported my taxes like this for two years in a row. As a result, I got back massive refunds from the IRS. I’m talking over $10,000 each year.
Not knowing any better, I used that money to help pay down my mortgage and spend on the house.
Big mistake.
A Second Set of Eyes
Thankfully, my Dad asked to look at my taxes. I think he became a little suspicious of the large refunds that I was receiving. To him, it didn’t add up. He looked at my taxes and immediately figured out that I had filed them completely wrong. I was double counting my mortgage interest.
Yes, I was very embarrassed. I had a degree in finance and was taking night classes in accounting. How could I make such a simple, but huge, mistake?
Seeking Professional Help
At that point, I hired a professional to help clean up my mess. I had to amend my taxes for two years and ended up owing close to $25,000 in back taxes. What a nightmare. Even though the IRS didn’t catch it, I still had to pay back-interest on the money that I owed.
It took years to dig out of this mess. I hired that same accountant to handle my taxes for the following ten years after that mistake. It wasn’t until last year, even though my tax situation became much less complicated five years ago, that I started to use online tax software again.
I’m not trying to deter you from filing your own taxes. This should only serve as a warning that mistakes can easily happen, especially if your specific tax situation differs from the general masses. TurboTax has improved tremendously over the last ten years. However, online tax software is not as foolproof as everyone thinks.
Ouch. Fortunately I have had no such tax filing issues and hope not to in the future. Tom
Tom @ Dividends Diversify recently posted…I’ve Heard Smoking Used To Be Cool
I hope for you case that doesn’t happen either 🙂
Yikes! That sounds horrible.
The first year we had rental income I forgot to report it at all. I didn’t realize it until I was pulling together tax information the following year. We of course had to amend the problematic taxes. Fortunately (I guess this was a good thing anyway) the rental income was only around $3000 so I don’t think it had much of an impact.
Mrs. College Rental recently posted…2018 Goals for College Rentals 101
Thanks for sharing Mrs. College Rental!!! Sounds like it wasn’t too costly of a mistake but that had to be a sinking feeling when it happened 🙁
Wow $25,000 in back taxes is a lot of money. I’m glad you found out early. We all make mistakes, and professionals do too, so don’t feel too bad about it.
The tax season is here. This post will come in handy for a lot of people. Thanks for sharing!
Ms. Frugal Asian Finance recently posted…7 Secrets About Personal Finance Bloggers
Thanks for sharing Ms. FAF!!! I know I’m being tough on myself but man $25k is nothing to sneeze at 🙂
I have been doing my own taxes for the last decade using a software. It’s actually very straightforward.
One of my reasons for doing my own taxes is to save money, but the real reason is to increase my wealth. I truly believe that it’s not how much money that you earned, it’s how much you get to keep after taxes. By knowing the tax code, I get to keep more of my money and direct them to tax efficient accounts so my money will grow tax sheltered until I withdraw.
In addition, I can also allocate my money to accounts that will minimize my taxes when I retire. Love it or hate it, income tax will not go away. So I might as well learn the rules, play within it and take advantage of rules that can help me keep more of my money.
Leo T. Ly @ isaved5k.com recently posted…Comparing The Greater Toronto Area Real Estate Prices With Other North American Metropolises
Thanks for sharing Leo!!! I definitely agree the more you know about the tax code the better off you are. I think every high school graduate should be required to learn how the tax code works, especially since they’ll use it the rest of their life 🙂
Ouch, that hurts! To date haven’t run into any issues and hopefully won’t. Thanks for sharing, also worth a second set of eyes, just to make sure.
FIbythecommonguy recently posted…DIY Basement Stairs
That’s awesome to hear that you haven’t run into any problems!!!
Ah man! Glad you were able to get out of the mess and hire an accountant!
Chris @ Duke of Dollars recently posted…Should We Live as a Mustachian? The Analysis of Extreme Frugality!
It was a huge mess and definitely well worth the cost to clean up my mess 🙂
We have someone else do ours (not a major software or chain).
I know for a fact I would screw it all up plus I’m sure they are way more aware of all the little things to do to max out our refund.
Budget On a Stick recently posted…2018 Goals, Not Resolutions
It’s definitely a nice peace of mind paying someone to handle your taxes. It’ll be interesting to see how the 2018 tax software works out. Hopefully all the bugs will be fixed 🙂
I think a great moral to the story is this: Don’t worry too much about filing your own taxes. Worst case is if you mess up, you can hire someone to help you fix the problem and learn from your mistakes. It’ll be okay!
As a tax professional, I’ve really found that the IRS is mostly concerned with people fraudulently misreporting than the average person that doesn’t know much about how taxes work. They have updated their systems so much to catch errors like this. Likely if you had made this mistake in current years, you’d receive a notice fairly quickly after your return was filed. As long as you fix the mistake and move on, you’ll be totally fine. And I do have to add that I do think a lot of people could benefit from hiring a tax professional, even if just for one year so that they have the confidence that the items on their return are correct and get some suggestions on better tax planning. And I’m not just saying that because I’m biased by being in the industry. I see loads of people that come in and save much more than the cost of their tax preparation.
Kathryn recently posted…How a Vision Board Will Help You Conquer Your 2018 Goals (Plus: Free Templates!)
The new tax plan was supposed to simplify the tax code. Not sure what happened with that.
dividendgeek recently posted…Reasons you should invest internationally
Hahhaa…I wish 🙂
Thanks for sharing Kathryn!!! I definitely agree having someone take a look at your taxes can more than save you the cost of the tax preparation. I know that it was a HUGE benefit for me 🙂
Thanks for sharing your story, MSM! I’ve made my fair share of oops’s as well, and have ended up filing multiple amended returns. It always pays to be a little more cautious!
Dan @ Pennies and Dollars recently posted…67 Insane Facts About Bitcoin
Thanks for sharing Dan!!! I’m right there with you. I wish I hadn’t made any mistakes but I guess you live and learn 🙂
I have been using online software for years now. Never come across any problem. In 2013 I had a slight complication due to taking money out of Roth IRA. Turbo tax online would not allow me to enter this amount. I ended up submitting my returns manually. IRS raised some queries, but I was able to provide answers and documentation. My take is trust but verify.
dividendgeek recently posted…Reasons you should invest internationally
Thanks for sharing DividendGeek!!! Sounds like a bit of a hassle but one that you were able to move through. That’s awesome to hear!!!
I’ve only ever had issues with my state return. I once forgot to remove the federal state tax deduction. The state caught it and I paid a 20 dollar late fee. Been filing my own taxes for twenty years though.
FullTimeFinance recently posted…Making Hay While the Sun Shines
Thanks for sharing Full Time Finance!!! Little mistakes happen, $20 in the grand scheme of things over 20 years is definitely not bad 🙂
I’m glad your dad took a look at your taxes and helped you figure out the mistake. I file myself, but have gone to a professional a couple of times for a sanity check especially since my wife was a contractor for a couple of years, received 1099 and had to set up a S-Corp due to the special employment, Also, I do parts of my taxes at different sittings and not all at once. I feel like this gives a fresh set of eyes each time.
That’s a great point SMM!!! Maybe this year I’ll do my taxes over a couple of days instead of cramming it all in one 🙂
I made the unfortunate error of assuming the company moved its business address when we physically moved from one state to another. I did file state taxes for both places, but only listed the 2 months for before the move. On the books it looked more like 6 months and the IRS had questions for me. They were nice and understood, when I explained. I have luckily not come across a similar situation since. I was definitely on edge when I got the letter from the IRS though.
Receiving a letter from the IRS is never good. I received a letter for state last year but it was to verify my identity. That’s much better than saying I made a mistake 🙂
I filed our income taxes wrong a couple of years ago and it cost us a couple of thousand dollars. I had to refile and come up with the money to pay the IRS. I liquidated my emergency fund to do it. In some respects, the new tax bill will be good because we will most likely no longer itemize, but I try to be as careful as I can nowadays to never have that happen again.
Thanks for sharing Jason!!! I’m waiting for a really simple tax code. I’d love to find one that didn’t involve income tax and used consumption taxes as the basis. I think that would be very interesting to see.
Oh man, taxes are such a hassle. I think I incorrectly filed my taxes for my first couple of returns, but made mistakes in favor of the government. Nothing big, but a loss for me.
Nowadays, I have an accountant prepare my returns because I have a complex tax situation and it just takes too much brain-energy to do it myself. However, I think it’s still necessary to know what’s going on – I have caught mistakes that could have cost me money, even using an accountant!
That’s the worst feeling having to double check your accountant. I fortunately didn’t find any mistakes but I had friends that did. Seems like such a waste to pay money for things to be wrong, even though I know people make mistakes…