ADU Tax Benefits and Deductions

# ADU Tax Benefits and Deductions

If you rent out your ADU, you can deduct mortgage interest, property taxes, insurance, maintenance, and depreciation - often reducing your taxable rental income by 30-50%. A $1,800/month ADU rental might only show $900-1,200/month in taxable income after deductions. These aren't loopholes or gray areas - they're standard rental property deductions the IRS expects you to take.

The catch: You need to actually use your ADU as a rental property, not primarily as personal space. But if you're renting it out legitimately, these tax benefits make the financial equation even better than the rental income alone suggests.

**Important note:** This article covers general tax principles. Tax situations vary widely, so talk to a CPA or tax professional about your specific circumstances. This is education, not tax advice.

## The Big Deduction: Depreciation

**What it is:** The IRS lets you deduct a portion of your ADU's value each year for 27.5 years, even though your ADU is likely appreciating in actual value.

**How it works:**
If your ADU cost $200,000 to build, you can deduct roughly $7,275 per year ($200,000 ÷ 27.5 years). This is a "paper loss" that reduces taxable income without any actual cash expense.

**Real example:**
"Our ADU generates $21,600/year in rent. After depreciation ($7,200) and other expenses ($5,000), we only pay tax on $9,400 of income. The tax savings are huge." - Portland homeowner

**The land exception:** You can only depreciate the structure, not the land value. If your ADU sits on land worth $40,000 of your total property value, you'd depreciate $160,000 of a $200,000 build cost. Your accountant can calculate the land percentage.

**What happens when you sell:** When you sell your home, you may owe "depreciation recapture" tax on the depreciation you claimed. Current rate is 25%. Many homeowners still come out ahead, but it's something to plan for.

## Mortgage Interest Deduction

**What you can deduct:** Interest paid on loans used to build your ADU - home equity loans, HELOCs, or construction loans.

**How much this saves:**
If you borrowed $180,000 at 7.5%, your first year's interest is roughly $13,500. That's a direct deduction against rental income.

**Real numbers:**
- Year 1 interest: ~$13,500 deduction
- Year 5 interest: ~$11,000 deduction
- Year 10 interest: ~$7,500 deduction

These deductions decrease over time as you pay down principal, but they're substantial in early years.

**Important limitation:** You can only deduct interest on up to $750,000 of total mortgage debt ($375,000 if married filing separately). For most ADU owners, this isn't an issue.

## Property Tax Deduction

**What you can deduct:** The portion of your property tax attributable to the ADU.

**How to calculate:**
If your ADU is 600 sq ft and your total improved property is 3,000 sq ft (main house + ADU), you can deduct 20% of your property tax bill.

**Real example:**
Total property tax: $6,000/year
ADU percentage: 20%
Deductible amount: $1,200/year

Your accountant may use square footage, assessed value increase from the ADU, or another reasonable allocation method.

## Operating Expenses: Fully Deductible

These are dollar-for-dollar deductions against rental income:

**Insurance:**
Additional coverage for the ADU or increased landlord policy: $500-$1,200/year

**Repairs and maintenance:**
- Plumbing repairs: Fully deductible
- Painting between tenants: Fully deductible
- Replacing broken appliances: Fully deductible
- Regular maintenance: Fully deductible

Track everything. Even a $50 repair adds up over a year.

**Utilities (if you pay them):**
If your lease includes utilities: $800-$1,500/year deductible

**Property management fees:**
If you pay 8-10% to a property manager: ~$1,600-$2,400/year on a $1,800/month rental

**HOA fees (if applicable):**
If your ADU triggers higher HOA fees, the increase is deductible

**Advertising and tenant screening:**
Costs to find tenants: Background checks, rental listings, showing expenses

**Legal and professional fees:**
Accountant fees for preparing Schedule E, lawyer fees for lease documents, etc.

**Supplies:**
Cleaning supplies, light bulbs, air filters - anything you buy for the rental unit

## What About Improvements vs. Repairs?

**Repairs:** Deduct immediately. These maintain existing condition.
- Fixing a leaky faucet: Repair
- Repainting after a tenant: Repair
- Replacing broken dishwasher with similar model: Repair

**Improvements:** Depreciate over time. These add value or extend life.
- Adding a deck: Improvement (depreciate over 15 years)
- Replacing roof: Improvement (depreciate over 27.5 years)
- Upgrading to premium appliances: Improvement (depreciate over 5 years)

The line can be blurry. Your accountant can help classify expenses correctly.

## Sample Tax Calculation

Here's what an actual ADU owner might see on Schedule E:

**Income:**
- Rental income: $21,600 (12 months × $1,800)

**Expenses:**
- Mortgage interest: $12,000
- Property tax (ADU portion): $1,200
- Insurance: $800
- Repairs/maintenance: $1,500
- Property management: $2,160
- Utilities: $1,200
- Depreciation: $7,000
- Other (accounting, supplies): $500

**Total expenses:** $26,360

**Net rental income (for tax purposes):** -$4,760

In this example, the ADU shows a paper loss despite generating $21,600 in actual cash income. That loss may reduce your other taxable income, subject to passive activity loss rules.

## The Passive Activity Loss Rules

**The limitation:** If you're a high earner and don't "actively participate" in managing your rental, you might not be able to deduct rental losses against your other income in the current year. The losses carry forward to future years.

**Active participation exception:** If your adjusted gross income is under $100,000 and you actively manage the rental (approve tenants, make management decisions), you can deduct up to $25,000 in rental losses. This phases out between $100,000-$150,000 AGI.

**Real-world impact:** Many ADU owners qualify for the active participation exception, especially in early years when depreciation creates paper losses.

## Short-Term Rental Tax Treatment

If you Airbnb your ADU, tax treatment can differ:

**Less than 14 days rented:** Income is tax-free (the "Augusta Rule"). Not realistic for most ADU owners but worth knowing.

**More than 14 days but you provide substantial services:** May be classified as regular business income, not passive rental income. Different rules apply.

Most ADU owners doing short-term rental should talk to an accountant about proper classification and whether they need to collect local occupancy taxes.

## What If You Use It Personally Sometimes?

**The rule:** You can only deduct expenses proportional to rental use.

**Example:**
If you rent your ADU 10 months/year and use it personally 2 months/year, you can only deduct 10/12 (83%) of expenses. Depreciation is also reduced proportionally.

**Strategic tip:** If you occasionally need the ADU for guests, consider whether personal use is worth reducing your tax deductions.

## State and Local Tax Considerations

**State income tax:** Most states follow federal rules for rental deductions, but verify with your state's tax agency.

**Local business licenses:** Some cities require rental business licenses. Fees are typically $50-$200/year and are tax-deductible.

**Transient occupancy tax:** If you short-term rent, you may need to collect and remit hotel/occupancy taxes. Check local rules.

## Don't Forget: ADU Increases Your Cost Basis

When you eventually sell your home, the cost of building your ADU increases your cost basis, potentially reducing capital gains tax.

**Example:**
- Home purchase price: $400,000
- ADU construction cost: $200,000
- Adjusted cost basis: $600,000
- Sale price: $850,000
- Capital gain: $250,000 (not $450,000)

This benefit applies even if you never rented out the ADU. The home sale exclusion ($250,000 single, $500,000 married) may eliminate capital gains entirely.

## Record Keeping: Boring But Essential

**What to track:**
- All construction and improvement receipts
- Monthly rental income (use rental software like Baselane or Stessa)
- Every repair, maintenance, and operating expense
- Mileage to manage the property
- Photos and dates of repairs

**Best practice:** Dedicated bank account or credit card for ADU rental income and expenses. Makes tax time infinitely easier.

## Work With a Professional

Every ADU owner's tax situation is different based on:
- Your other income and tax bracket
- Whether you actively manage the property
- How many months you rent vs. use personally
- Your state's specific rules
- Your long-term plans for the property

A good CPA who understands rental properties will typically save you more in taxes than their fee costs. For a few hundred dollars at tax time, you'll have peace of mind and maximize legitimate deductions.

## Start With What You Can Control

You don't need to become a tax expert before building an ADU. You need to know that significant tax benefits exist and that tracking expenses from day one makes everything easier.

**Your next steps:**
1. Check if your property qualifies for an ADU [property checker link]
2. Get cost estimates from local builders [builder directory link]
3. As you move forward, set up a simple system to track all ADU-related expenses
4. Talk to a CPA once you're seriously planning construction

The tax benefits are real, substantial, and available to any ADU owner who follows the rules. They're another reason why the ADU investment math works better than it appears on the surface.