It’s no secret that building and renting out an ADU provides passive income. At the same time, a lot of people don’t consider the tax ramifications of this investment. You will pay more in taxes at the end of the day, but this amount is insignificant compared to what you can potentially earn.
Here’s what you need to know to do the math for yourself:
What Is an ADU?
An accessory dwelling unit, or an ADU, is a separate unit located on a single-family or multi-family property. This unit must have its own sleeping area, kitchen area, and bathroom to be considered a legitimate ADU. ADUs have a wide range of floor plans and use cases depending on your budget and goals.
What Are the Different Types of ADUs?
There are three different types of ADUs to consider: attached, detached, and conversion.
An attached ADU is essentially an addition to the main home. Building this type of ADU typically does not require separate utilities to be run and can be a cost-effective option whenever backyard space is a premium.
A detached ADU is a completely separate structure from the main home. Building this type of ADU involves all the elements of construction: site preparation, foundation, framing, roofing, and all the other elements that go into a completed new construction build.
A conversion ADU involves converting an existing space within the main home into a separate unit that qualifies as an ADU. For instance, adding a kitchen and a bathroom to the basement of a home would count as a conversion ADU.
Should You Build an ADU?
Building an ADU is an important financial decision that should be made on an informed basis.
Here are some of the pros and cons of building an ADU that you need to consider:
- Building an ADU can increase your property value which is beneficial when you decide to sell your property.
- Building an ADU can provide you with passive income if you decide to rent it out.
- Building an ADU can provide you with the extra space you need to work from home, have guests over, house an aging parent, etc.
- Building an ADU can cause your property taxes to increase—but only for the assessed value of your ADU, and does not trigger a re-assessment of the main home.
- If you’re earning additional rental income, building an ADU can cause your income taxes to increase.
Taxes are always a big concern — and for a good reason!
So here’s what you need to know about how an ADU will affect your taxes...
How Does an ADU Impact Property Taxes?
Property taxes are a pretty large expense for homeowners in addition to principal, interest, and insurance. Thankfully, paying property taxes is made relatively easy thanks to escrow accounts that collect 1/12 of the value of your annual property taxes on a monthly basis.
Then when it comes time to pay your annual taxes, you have enough money in your escrow account to cover the balance. This approach is less painful than having to pay them in a lump sum.
That being said, no one likes paying property taxes, so it makes sense that you’d be concerned about the effect that an ADU would have on your property taxes.
So let’s spell it out:
- Your property taxes will increase as a result of building an ADU but only based on the value of the ADU itself. The ADU does not trigger a property tax reassessment of the existing main home.
- So if the assessed value of your ADU is $100,000 and the property tax rate is 1%, then you will need to pay an extra $1,000 in property taxes each year.
- The value of your ADU depends on a whole host of different factors. If you build a detached ADU, the odds are that it will add a lot of value. On the other hand, if you simply convert your basement into an ADU, it will likely add less value — or none at all.
How Does an ADU Impact Income Taxes?
Now that you know how an ADU impacts property taxes, you might be wondering how it would impact income taxes. The answer is that it depends on how you’re using the ADU. If you’re using the ADU as an extra office or guest space, then it would not impact your income taxes whatsoever.
On the other hand, if you rent out the ADU either in the short-term or the long-term, you would have to report the income you earn from the unit on your income taxes. It’s impossible to determine exactly how much this would impact your taxes without consulting an accountant or listing out the full details of your ADU rental income, but it’s still an important factor to keep in mind when deciding on building an ADU.
Will Adding an ADU Require a Reassessment?
Thankfully, adding an ADU to your property will not require you to undergo a reassessment of your property taxes. This is excellent news as many homeowners are currently paying property taxes on an amount substantially lower than their house is actually worth.
Say the assessed value of your home is $300,000, but this assessment is from years ago, and since then, your house has risen in value approximately $450,000. And let’s say that you pay a property tax rate of 1% of the assessed value.
As it stands, you currently pay $3,000 a year in property taxes, but a reassessment would cause you to pay $4,500 — a $1,500 or a 50% increase in your property taxes.
Instead of using this costly approach, only the value of the ADU itself is assessed for property tax purposes.
How To Reduce the Tax Burden of an ADU?
No one likes paying taxes, so is there any way that you can reduce the tax burden of an ADU to make it a more economically feasible option?
Here’s what you need to know:
Use an LLC
You could potentially wrap your existing and/or ADU in a Limited Liability Company (LLC) to reduce the tax burden if you’re going to be renting out the space. This setup is beneficial as it allows you to deduct startup costs and organizational expenses from your taxes for a maximum deduction of $5,000, which is reduced dollar-for-dollar by the amount over $50,000. From there, any remaining eligible costs not immediately deducted are amortized over 15 years.
In addition, the cost of the ADU itself can be depreciated over 27.5 years. This time period begins the month the ADU becomes available for rent. For example, if you listed your ADU for rent in January and it cost you $100,000, then the first year’s depreciation would be $3,485.
Finally, using an LLC can offer you and your ADU additional protections that extend past taxes. For instance, renting out your ADU through an LLC protects your personal assets like your home should anything happen with the unit.
ADUs are rising in popularity as affordable housing solutions. Some cities with low housing inventory have recognized this and have launched or proposed incentive programs for building ADUs. In Portland, for instance, there are special programs that offer reduced construction costs and fees if the unit is then rented to a low-income tenant.
And while this tip doesn’t necessarily reduce the tax burden of an ADU, it could help make it more affordable and achievable. So before you totally discount the idea of building an ADU based on cost alone, check to see if your area offers any incentives to make it more feasible.
Final Thoughts on Taxes and ADUs
When done right, building an ADU is well worth the small increase in taxes. Working with a professional and experienced ADU builder can help ensure that you can rent out the unit for top dollar and offset the increase in property taxes.
Reach out to Cottage for a complimentary consultation to learn more!