I’m looking for general thoughts and direction for how to handle the various tax implications of building and renting out an ADU (accessory dwelling unit) on my primary residence property.
Many states and cities are relaxing zone codes to allow homeowners to build ADUs or second units on their single-family zoned property. In my state (CA), newly passed legislation will allow a single-family homeowner to build between 3- 4 total units on their property. I see that many people are jumping on this bandwagon bedazzled by the promise of extra income (especially since rental rates are ridiculously high right now).
Aside from wondering what will happen to the quality of housing and property values a few years down the road with so many amateur landlords around, I also wonder what the tax ramifications will be for individuals that go this route.
For example. Let’ say Couple A owns a single-family home as a primary residence has lived there for 10 year. Over that course of time the property has realized (on paper) substantial capital appreciation in the property. Couple A decides to tap into that equity and use it to finance improvements and new construction on that same property. They decide to build two ADU’s on the same lot and with the intent to rent those new units out to various tenants and collect the rent as passive income. Couple A continues to live in the primary residence. After five years, Couple A decides to sell the property (i.e., a single lot with one primary residence dwelling and two ADUs).
Is Couple A still eligible for the $250K/$500K capital gains exclusion even though the property was used as rental property for the previous five years?
Would Couple A have to track “primary residence” costs/improvements separate from ADU/rental costs and improvements and pro-rate accordingly or could the property be tracked as a whole under the umbrella of the primary residence?
For annual tax reporting, would Couple A have to declare depreciation on the rental units? If upon sale that depreciation has to be added back to the cost basis, could the capital gain (presumably) increase created by that action be neutralized by the same $250K/$500K capital gains exclusion that may (or may not) be allowed for the primary residence?
I know that renting out a back-unit or guest house on a property is not an uncommon situation. And duplexes and triplexes happen. But I suspect that in the past a lot of that has happened somewhat “under the table”. In this new era of ADUs, the newly tracked permits and assessor tax roles will easily be able to ferrate out properties that are being set up for rental income and should therefore be reporting income and paying taxes on such.
This is intended to be general and open-ended questions. I am interested to hear people’s thoughts and experiences. I am considering adding a glorified guest-house/ADU to my own property but would probably just want to allow friends/family who need a temporary place to stay. Not sure that I’m up for dealing with the hassle of having real tenants on my property, but still want to consider all the angles.
I would point out that whether or not Couple A declares depreciation on the rental units, depreciation that should have been claimed will be recaptured upon sale and taxed. So, choosing not to declare depreciation on the rental units will be penalized when they sell.
Thank you for your replies, @ptheland and @aj485. Peter makes the tax reporting appear to be fairly straightforward.
Here is a follow-up question. If the ADU is new construction, built solely for the purpose of establishing the ADU to generate rental income, are the entirety of those construction improvement costs tracked with the “business asset” component to reflect the cost basis for that new rental business use? And if so, how is the underlying land value sorted out? Is it simply pro-rated to each the personal residential and business uses?
What about a scenario where the ADU is created from an existing structure that was previously associated with the personal residential use (e.g. the conversion of a garage or guest house to an ADU)? Does the entire value of that structure get re-assigned to the newly created rental business use or do only the construction improvement costs that are tied to the conversion itself get tracked for the cost basis?
Yes. And that one-word answer makes it sound much easier than it is.
You’d start by allocating the original purchase of the property between the dirt - which is not depreciated - and the building - which IS depreciated.
Then when you construct the ADU, you need to allocate some of that land value to the newly built ADU.
How you do that is more art than science. You just need some reasonable basis for the allocations.
Same thing, in theory. Allocate the original purchase price between land and building. Then split each on some reasonable basis between personal use and rental use. Then add in any construction costs associated with creating the rental to the rental portion.
Again, lots of art, little science.
PS - In art, beauty is in the eye of the beholder. What you see as a beautiful allocation the IRS may see as ugly. So be prepared to defend your definition of beauty.
This is a really interesting and inspiring thread. I had not known about ADU’s and this has piqued my interest.
We live in a 4-bdrm / 2.5 bath home that is probably not conducive to aging in. All bedrooms are on the second floor, and there is no space to install an elevator
We do however, have 1.5 acres of land which could potentially be buildable in the back of our current home. I think that building a small home in the back of our existing home could be an interesting option for us. My understanding is that we would not have sufficient frontage to build another home on this parcel of land according to current zoning standards in our locale.
I’d have to check with our local building inspector to see if there is an option for us to do this within existing building codes and if not, would the town be considering ADU’s as an option for residents.
I’d also have to do some thinking about how this might affect the resale value of our current home. I’m not sure if this would be beneficial to the overall resale value or not. Considering that more and more folks seem to be thinking about how to reduce costs as we age, maybe this may not be as much of a negative as I am initially thinking…
I have experience working with contractors on residential building projects so this would be something that I would be fairly comfortable doing.
I’ll have to chat with DW to see if she would be open to the idea. I’m open to others who might want to lend me their thoughts on this as well.
You might have several options. You have a large lot and could think about subdividing to have a standard lot (along the street) and flag lot (for a potential additional primary single-family unit off of the street). But if you don’t want to own two lots (or have the added expense of processing a lot-split), then an ADU may be the way to go.
ADUs are becoming much more common and acceptable under zoning codes because it does accommodate affordable housing and extended family housing options. CA passed state-wide legislation that requires local agencies to incorporate provisions for ADUs in their respective zone codes/development standards. Not all states have gone to that model, but many jurisdictions have this provision regardless. Often the ADU standards establish size restrictions for these second units. Even so, standards for some jurisdictions are pretty generous and flexible with the setback requirements.
Since you mentioned that you have a large property, if you have any sort of livestock or such on your land, you might also check to see if your zoning would allow for you to have a “caretaker” unit on-site. Provisions for caretaker units are more common with agricultural properties or properties with an associated business where someone needs to be present on-site for oversight or security purposes. Standards for caretaker units don’t usually come with the size restrictions that might apply for an ADU.
You might want to take your idea over to the Building and Maintaining a House board and see what experience that group might have to offer.