Tax Benefits of ADUs — Why ADUs Are an Excellent Investment

Tax Benefits of ADUs — Why ADUs Are an Excellent Investment

What are the tax benefits of ADUs?

As the tax season draws near, our customers come to us with tax-related questions more frequently. Mainly, they ask us how an ADU could potentially affect their taxes and what are the tax benefits of ADUs. Although they pretty much already know that an accessory dwelling unit (ADU) will increase the value of their property, many are still in the dark about how an ADU construction will change their tax rate. 

That’s why today we’re talking about all the potential tax benefits of ADUs. Overall, since ADUs are an excellent investment, adding an ADU to your property will come with significant tax deductions. However, it will also increase your property taxes.

So, to plan and build your ideal ADU, you need to be fully aware of each and every nuance that has to do with ADUs and taxes. But don’t worry; that’s why we’re here!

Navigating the Californian Housing Market  

adu tax benefits

Do you already have a single-family home? Then you’re doing much better than most, given that California’s homeownership rate is in steady decline. Not to mention, the affordable housing crisis is hitting an all-time high. That’s precisely why the Californian government is encouraging people to build more ADUs

We’ve already touched on this topic many times. However, it’s important to note again that ADUs are practically a win-win type of deal for everyone involved. 

Building one will bring significant monetary benefits to property owners since they can rent them out and earn extra income. The government benefits because ADUs help them provide affordable housing to people. In the wake of the global pandemic and all its effects on people’s incomes and livelihoods, that is a huge deal. Not to mention, ADUs have the real potential to impact the housing market long-term.

Therefore, it’s no secret that building an ADU next to your existing home is beneficial. But, aside from providing an extra income (or more space for you), how will it affect you?

Property Tax and ADUs

The main concern (or at least the first question our clients usually have) is how an ADU will affect their property taxes. After all, you’re adding more value to your home. Not to mention, the ADU will be assessed for tax reasons by the relevant government institutions. Does that mean your home will also get reassessed?

Thankfully, no. 

Prop 13 ensures that your property taxes can’t skyrocket along with the value of your home (which is steadily increasing with every passing year of the housing crisis). Prop 13 lowered the property taxes to 1% of the current value of your home and capped the annual increase rate to 2%. 

But what happens if you add value to your home with a massive change. In other words, what happens if you add another dwelling unit to it? Surely that will increase the value of your home and trigger a reassessment?

Again, no. Adding an ADU doesn’t mean your home will get reassessed in value. In fact, the ADU will be assessed as a stand-alone unit, or rather as an addition to your home. So, it might trigger a blended reassessment, but it won’t increase your property tax by a lot.

To put it in simpler terms, if you build an ADU that has a value of $100,000, the property tax on that will be around $1,000 (since it’s capped at 1%). That will then be added to your existing property tax that you pay annually (so, it will blend with your current tax rate).

The Nuances of the Californian Tax System

Generally speaking, California is below the national average when it comes to property tax. Of course, property tax varies from area to area (meaning you won’t pay the same property tax in Los Angeles as you would in some other places). But, on average, the property tax rate in California is around 0.73% of the property’s value

That’s significantly lower than the national average, which is around 1.07%. 

That’s not bad for a state that has exceptionally high state taxes that it enforces diligently and somewhat aggressively. With high individual and business tax rates (that are 13.3 and 8.84%, respectively), Californian property tax isn’t that bad.

Not to mention, calculating the added tax rate that will increase your overall tax rate when you add an ADU doesn’t necessarily depend on how much money you put into the project. The added value isn’t always the determining factor.

So, you won’t calculate the added rate based on how much money you spent on your new ADU. Instead, the rate will change based on the “real added value” to your property. This real value is determined based on:

  • Potential income 
  • Values of similar properties (that have been sold recently in your area)
  • Cost of improvements

The latter is determined by the actual cost of construction and the State Board of Equalization tables.

Additionally, some cities and counties may have specific fees that will go into your overall cost. But, even with all that, ADUs won’t significantly increase your property tax rate. It will always depend on the amount of money you invested and the realistic value you’ve added to your home, but they’ll never be as exorbitant as many homeowners fear.

Tax Benefits of ADUs

adu taxes

So, while we know that ADUs can increase your property taxes, let’s see how they can benefit you monetarily. Adding an ADU, as mentioned, is a great investment. It allows you to:

  • create more space on your property
  • start a rental business
  • create passive income

Given that the tax season is drawing near, now is the time to think about investments that will look good on your tax returns, and that will be potential deductions. ADUs are one of the best choices for that. 

Since they are fully functioning housing units, they make for excellent rental properties (especially if they are detached ADUs). Given that California frowns on using ADUs as short term rentals, with Los Angeles going as far as banning the use of ADUs as AirBnBs, you’ll need to find a long-term renter for your new business.

But even on the off chance that your area allows short-term rentals, you’ll still need to protect yourself and your property. If you’re building an ADU in order to contribute to solving the affordable housing crisis (in other words, to rent it out), then the smartest idea is to wrap your new ADU in an LLC.

Limited Liability Company and ADUs

If you’re going to rent out your new ADU, the best way to do it is under an LLC. An LLC is a Limited Liability Company that will protect you and your assets (both the ADU and your existing home) in case something happens with your tenants. 

Having that extra layer of protection is fantastic. However, that’s not all that an LLC can offer you. 

If you wrap your ADU in an LLC, you’ll be able to deduct the cost of startup expenses. So, you’ll deduct all those soft costs that don’t have anything to do with the actual construction (like the cost of pulling permits or architect and planning fees). You’ll also deduct organizational expenses. All charges that have to do with setting up your LLC will be deductible.

So, technically, you could deduct the cost of up to $5.000 for a one-person LLC. The maximum deduction of $5.000 comes dollar-for-dollar for all amounts that go over $50.000. If your startup costs go above $5.000, you won’t be able to deduct them immediately, but they will be amortized over the following 15 years.

Depreciation of the Overall Cost of ADUs

Aside from deducting startup costs, an LLC will also allow you to depreciate the overall cost of your new project over a period of 27.5 years. The depreciation will start the first month you go into business. In other words, as soon as your ADU is done and you make it available for rent, you’ll be able to recognize the ADU as a depreciation expense.

So that means that even if you don’t have a person or a family ready to move into your new ADU, you’ll still be able to depreciate it, as long as it’s available for rent. 

LLC and ADU

When it comes to other tax benefits, it’s important to note that one-person LLCs are disregarded in terms of tax both for single and married people. Your new business income (provided that you have a renter) will be recorded directly on your tax return. All your expenses will be written off, and you’ll enjoy the legal protections of an LLC, which means you’ll only pay taxes on your rental income once.

How? Well, all that extra income, as well as the expenses that you have (that are related to the ADU), will find their way to your Schedule E form, which will end up on the first page of your tax return.

Cedar ADUs — the Best Way to Make an Investment

The tax benefits of ADUs are vast and often overlooked. Building an ADU in your backyard can significantly change your tax forms, especially if you’re planning on renting that unit out. 

Having a property that earns income from renting will deduct depreciation as an expense. In other words, it will allow you to lower your taxable income. That, in turn, might even reduce your tax liability

Do you want to start your own business and become a landlord by building and renting out your ADU? The Cedar team is more than happy to help. 

Our turn-key solutions provide you with the opportunity to start your business without much hassle. We’ll do everything for you! We’ll even help you with financing and finding renters. All you have to do is book a free consultation!