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 used to “significantly improve” your property.
The IRS considers these improvements to be anything that increases your home’s value, extends its life, or changes its use—like building an ADU. For example, if you took out a $100,000 home equity loan to build the ADU, the interest on that loan could qualify for a tax deduction.
However, these deductions follow the same limit as mortgage interest, which is up to $750,000 in total mortgage debt ($375,000 if married and filing separately). The loan also needs to be secured by your home, meaning it must be tied to your property, not just a personal loan.
How Homeowners Can Maximize Their ADU Deductions
Taking full advantage of the tax deductions related to your ADU requires a strategic approach. Here are some practical tips you can follow to make sure you’re getting the best tax benefits from your ADU project:
1. Keep Detailed Records
The IRS requires documentation for all tax deductions, so having detailed records will help you claim every deduction you’re entitled to without any problems during tax season or in case of an audit.
Some key expenses to track include:
- Construction costs
- Repair and maintenance costs
- Utilities and insurance
- Loan interest
You should set up a dedicated folder or software system to organize these expenses throughout the year. This way, when tax season arrives, you’ll have all the necessary documentation ready.
2. Hire a Tax Professional
Tax laws surrounding ADUs can depend on things like how you use the ADU, how long it’s rented out, and any changes to tax regulations. To ensure you’re making the most of available deductions, consider working with a tax professional, especially one experienced in real estate or rental property taxation.
A qualified tax professional can:
- Properly Categorize Expenses: It’s important to know which expenses can be deducted right away and which ones need to be spread out over time through depreciation.
- Help with Depreciation: Depreciation can be complex, especially if you only rent your ADU part of the time. A tax advisor can calculate the correct depreciation amount and guide you through how much of the ADU’s expenses are deductible based on its usage.
- Navigate IRS Guidelines: The IRS is strict about the rules for rental properties and personal-use dwellings. A tax professional can make sure you follow the rules, report rental income correctly, and avoid expensive mistakes when dealing with ADU-related taxes.
3. Stay Updated on Tax Laws
The tax code changes frequently. You must keep up with these changes to ensure you’re claiming all the deductions for which you’re eligible. This is particularly true for real estate and rental properties, as lawmakers are constantly adjusting policies related to property taxation, rental income, and capital gains.
New deductions may become available, or existing ones may be eliminated. Thus, it’s important to stay informed. You should schedule an annual or semi-annual meeting with your tax advisor to discuss any changes in tax laws and how they might affect your ADU deductions.
FAQs
1. How do I report income and expenses from my ADU on my tax return?
You’ll report income and expenses from your ADU rental on Schedule E (Supplemental Income and Loss) when filing your taxes. This form allows you to list rental income, deductible expenses, and depreciation.
2. Are there any tax credits available for building an energy-efficient ADU?
Yes, you may qualify for certain tax credits if your ADU incorporates energy-efficient systems, such as solar panels or energy-saving appliances. Check federal and state programs for available incentives.
3. Can I deduct property management fees for my ADU rental?
Yes, if you hire a property manager to oversee your ADU rental, the fees you pay are typically deductible as a rental expense.
Conclusion
If your ADU serves as a rental property, you could be eligible for several deductions, including depreciation, repairs, and maintenance costs. However, even if your ADU is used for personal reasons, certain loan interest deductions may still apply.
To make the most of these opportunities, it’s essential to keep detailed records, understand your ADU’s tax classification, and consult with a professional to avoid any potential pitfalls.
If you’re considering building an ADU, our team at GoldenADU is here to assist. Contact us for a free consultation at 213-693-2405 to learn more about the potential tax benefits of an ADU.
