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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.
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.
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.
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.