Are ADU Expenses Tax Deductible?
Accessory Dwelling Units (ADUs) have increased in popularity as homeowners look for ways to create rental income or provide extra living space for family members. However, a common question comes up: Are the costs of an ADU tax-deductible? As with many tax-related matters, the answer depends on how you plan to use the ADU. In this guide, we’ll look into the possible tax benefits of building an ADU, discuss which expenses might be deductible, and explain how to make the most of these tax advantages. How the Use of Your ADU Impacts Tax Deductions Recently, I had a conversation with one of my clients who was in the process of turning her detached garage into a beautiful ADU. She was excited about the extra rental income it would bring. However, she was also unsure about the tax benefits that might come with it. During our conversation, she asked if her ADU expenses were tax-deductible. She wanted to know if the money spent on construction, maintenance, and other costs could help her save on taxes. The answer to that depends on how you use your ADU. Whether you’re planning to rent out your ADU, use it for personal purposes, or a mix of both, the way you use your ADU will greatly affect your potential tax deductions. Let’s break down the specifics to help you understand what you might be able to deduct. 1. Rental Property If you primarily use your ADU as a rental property, the IRS considers it a business or income-generating asset. This classification allows you to claim more tax deductions, reducing the cost of owning and maintaining your ADU. Here’s a closer look at the specific tax deductions you can take advantage of: Construction Costs You can’t deduct the total construction cost of your ADU in a single tax year. However, you can spread out these costs over 27.5 years, which is the standard depreciation period for residential rental properties. This long-term deduction can significantly reduce your taxable rental income each year, effectively lowering your tax liability. For example, if you spent $150,000 to build your ADU, you could claim approximately $5,454 per year as a depreciation expense. Repairs and Maintenance Costs Repairs such as fixing a broken pipe, replacing worn-out appliances, or patching up damaged drywall can all be written off as expenses in the year they occur. These repairs must be reasonable and directly related to maintaining the ADU. However, you need to clearly distinguish between repairs and improvements. Repairs restore the ADU to its original condition and are fully deductible in the year they’re made. On the other hand, improvements, like upgrading the kitchen, must be capitalized and depreciated over time, similar to construction costs. Utilities and Insurance If you rent out your ADU, you might be able to deduct part of your property’s utility bills (such as water, electricity, gas, and internet) and homeowners insurance on your taxes. The percentage of the amount you can deduct usually depends on how much of your property the ADU takes up. For example, if your ADU makes up 25% of the total square footage of your property, you could potentially deduct 25% of your utility and insurance expenses as business-related costs. 2. Personal Purposes When you use your ADU for personal reasons—such as providing living space for family members and guests or as a home office—the IRS generally classifies it as part of your primary or secondary residence. In this case, the major tax deductions related to rental income, such as depreciation and repairs, don’t apply. Since the ADU isn’t producing any taxable income, it’s treated just like other personal-use spaces in your home. However, you might still get some deductions, especially if you rent it out part-time or if you took out a home improvement loan to build it. 3. Mixed-Use Scenario Sometimes, homeowners may use their ADU for both personal and rental purposes throughout the year. For example, you may live in the ADU part of the year and rent it out during peak seasons. In this situation, the IRS allows you to deduct expenses based on the amount of time you rent out the ADU. In this scenario, you’ll need to keep detailed records of how many days the ADU was rented versus how many days you used it personally. Your deductions should be adjusted based on this. For example, if you rent out your ADU for six months and live in it for the other six months, you can only claim 50% of the depreciation, repairs, and utilities related to the rental period. Tax Deductibility of ADU Loans If you took out a loan to construct your ADU, you should be aware of potential tax benefits. In some cases, the interest you pay on loans for home improvements, like building an ADU, can be tax-deductible. This will depend on the type of loan you have and how you’re using the ADU. 1. Mortgage Interest Deduction for ADUs Generally, mortgage interest can be deducted if the loan was used to buy, build, or significantly improve your main home or a second home. Since an ADU is considered part of your primary or secondary home, the interest on these loans often qualifies for the mortgage interest deduction. However, the Tax Cuts and Jobs Act (TCJA) of 2017 set limits on how much mortgage debt qualifies for this deduction. As of 2023, you can deduct interest on up to $750,000 in total mortgage debt ($375,000 if you’re married and filing separately). This limit applies to all your mortgage debts combined, including any loans used for an ADU. If your total loan balance is higher than these limits, your deduction could be reduced. 2. Home Equity Loan and HELOC Interest Deductions Home equity loans and Home Equity Lines of Credit (HELOCs) are common ways to finance ADU projects. If you used one of these options to build your ADU, the interest you pay on the loan might be tax-deductible as long as the loan was