Taxes and ADUs?
Are you thinking about building an accessory dwelling unit (ADU) so you can generate rental income? Perhaps your ADU is going to be used to house your family members? The benefits of building an ADU are endless, but the one concern that many homeowners get hung up on is the added property taxes, if any.
Don't let taxes stop you from building an ADU
In California, property taxes are typically 1% of the property's assessed market value. The construction of your ADU will trigger a reassessment, but it will be a blended assessment. The ADU will be assessed by itself. Whatever the determined market value is will generally be assessed a 1% tax and added to your current tax bill (making it a blended rate). Know that over time, your tax rate can increase but is capped at 2% thanks to Prop 13.
Let's consider this example of how taxes could play out. If your ADU is valued at $100,000 then your tax bill would only increase by $1,000 ($100,000 x 1% = $1,000). That amount is further reduced if you spread it over 12 months; the tax impact of building your ADU is only $83 per month. Compare that to the potential rent you would collect for your ADU. Whether you charge $1,200 or $2,200 per month for your ADU, it will be more than enough to justify the added property taxes... in this example, 14 times more than enough!
Protecting yourself and a bunch of benefits
Consider wrapping your ADU in an LLC. If a mishap were to happen with your ADU renter, then rest assured knowing you and your assets (like your existing home on the property) are protected. The benefits of running your new rental business under an LLC, aside from the protection, is being able to deduct all the startup costs (architect fees, permit fees, and other soft costs) as well as organizational expenses (all charges incurred to create the LLC entity). The maximum deduction is $5,000, which is reduced dollar-for-dollar by the amount over $50,000. Any remaining startup costs and organizational costs not immediately deducted is amortized over 15 years.
The cost of the ADU itself is allowed to be depreciated over 27.5 years, starting the month the ADU becomes available for rent. Said differently, you get to write off a huge expense (depreciation) as soon as your ADU is completely built and available to rent. Even if you don't have a renter in the ADU, as long as the unit is made available (e.g., is listed 'for rent' online or in the local paper), then you get to recognize the depreciation expense. If your ADU cost is $100,000 than assuming it was available for rent January 1 than the first year's depreciation would be $3,485 ([$100,000 / 27.5 years] x [11.5 / 12] = $3,485.85)
LLC's are disregarded for tax purposes whether you're married or it's just you. The business income is recorded directly on your tax return, which is a good thing because you're getting the legal protections of an LLC and writing off almost all the expenses (including depreciation) and then only having to pay taxes once on the income. All of your rental income and expenses will be captured on your Schedule E, which flows to page 1 of your tax return, which is also a benefit!
There is a lot to consider about your accessory dwelling unit. There is much information out there, and yes, you could do this by yourself. Things to think about are: how are you going to finance the construction costs, what architect are you going to use, the time required and the added expenses to pull permits, all the different contractors and inspections involved. There is only one company out there that can hold your hand every step of the way, ADU Geeks.
Give them a call and let them help you determine if an ADU is right for you and your family. They can finance, design, pull permits, build, and even lease your ADU.
Remember, ADUs are not only a great way to generate additional income every month, but it's also a way to create immediate equity. Stay tuned for my next blog about ADUs and how it's a guaranteed way to generate instant equity. We homeowners literally cannot afford not to build an ADU!
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.