I'm going to build an ADU (accessory dwelling unit) on my rental property. It will be a detached separated unit. How do I deduct the costs of construction?

Constructing assets.   If you build property or have assets built for you, your expenses for this construction are part of your basis. Some of these expenses include the following costs.

    Land, [ land is separate ,land is not depreciated must allocate some cost to land]

    Labor and materials,

    Architect's fees,

    Building permit charges,

    Payments to contractors,

    Payments for rental equipment, and

    Inspection fees.

perating and maintenance costs for equipment used in the construction; and

    The cost of business supplies and materials used in the construction.

Do not include the value of your own labor, or any other labor you did not pay for, in the basis of any property you construct. 

Hi,

would this logic be the same if I’m building an ADU (detached) to my primary house that I’m living in right now? 

Im also in the process of building an ADU but it will not be completed until April of 2020. Can I deduct the construction cost and everything that the OP mentioned when I filed my 2019 tax return?

would this logic be the same if I’m building an ADU (detached) to my primary house that I’m living in right now?

Yes. But understand this is not "logic". It's the law.  The construction adds to the cost basis of the property. What you're doing is more accurately termed a "property improvement". Property improvements are never deductible per-se. They add to the cost basis of the property. If the property or any part of the property will have any type of business use (which is what rental property is) then the property or portion of the property used for said business is capitalized and depreciated over time.  Below are some definitions that will help clarify things for you.

RENTAL PROPERTY ASSETS, MAINTENANCE/CLEANING/REPAIRS DEFINED

Property Improvement.

Property improvements are expenses you incur that add value to the property. Expenses for this are entered in the Assets/Depreciation section and depreciated over time. Property improvements can be done at any time after your initial purchase of the property. It does not matter if it was your residence or a rental at the time of the improvement. It still adds value to the property.

To be classified as a property improvement, two criteria must be met:

1) The improvement must become "a material part of" the property. For example, remodeling the bathroom, new cabinets or appliances in the kitchen. New carpet. Replacing that old Central Air unit.

2) The improvement must add "real" value to the property. In other words, when  the property is appraised by a qualified, certified, licensed property appraiser, he will appraise it at a higher value, than he would have without the improvements.

Cleaning & Maintenance

Those expenses incurred to maintain the rental property and it's assets in the useable condition the property and/or asset was designed and intended for. Routine cleaning and maintenance expenses are only deductible if they are incurred while the property is classified as a rental. Cleaning and maintenance expenses incurred in the process of preparing the property for rent are not deductible.

Repair

Those expenses incurred to return the property or it's assets to the same useable condition they were in, prior to the event that caused the property or asset to be unusable. Repair expenses incurred are only deductible if incurred while the property is classified as a rental. Repair costs incurred in the process of preparing the property for rent are not deductible.

Additional clarifications: Painting a room does not qualify as a property improvement. While the paint does become “a material part of” the property, from the perspective of a property appraiser, it doesn’t add “real value” to the property.

However, when you do something like convert the garage into a 3^rd bedroom for example, making a  2 bedroom house into a 3 bedroom house adds “real value”. Of course, when you convert the garage to a bedroom, you’re going to paint it. But you will include the cost of painting as a part of the property improvement – not an expense separate from it.

Thank you for the reply Carl.

i just have one quick follow up question. So once the ADU is ready to be rented or a tenant rents it out, can I depreciate the ADU? If my ADU total cost is $150k and my current land value is $450k (not including my primary house building), what’s the depreciation amount I should enter? Thank you in advance for your help

I've included some additional clarifications for you at the end of my post here.

So once the ADU is ready to be rented or a tenant rents it out, can I depreciate the ADU?

Yes. But understand when depreciation starts. The depreciation starts on the first day the property is "available for rent". Not the first day the renter moves in. So basically, it starts when you place that "for rent" sign in the front yard. Doesn't matter if it takes you three months to actually get a renter in it. So long as "YOU" don't utilize the property for personal use, depreciation starts when it's available for rent.

There's two basic dates you'll deal with on this. First, is the date of acquisition (or completion of construction in your case). This is referred to as the purchase date or acquisition date. The 2nd date is the "in service" date, which is the first day the property is available for rent.

what’s the depreciation amount I should enter?

The information provided here is specific to your case, and your situation *only*. It may not apply to anyone else that may be reading this thread.

As I understand it, we're talking about a physically separate structure that may or may not be attached to your primary residence. What you will need to do is a bit of allocation. If what you will be renting out is what you paid 150K for and you will not be renting out any more or less than that, then your structure value will be 150K. Then you will need to allocate a percentage of your land value too. Here's a sample example.

I purchased my home in 2003 for $100,000. I have never rented it out. At the time of purchase/acquisition the structure value was $70K and the land value was $30K. In 2019 I added on to my house another living structure that was composed of a bedroom, bathroom and kitchen. This addition cost me $50K.

Prior to the addition the total square footage of my structure was 2500 sq ft. After the addition the total square footage of my structure is 3500 sq feet. That means the new addition of 1000 sq feet is 1/3 or 33% of my total square footage. Therefore I will allocate the total cost of $50K I paid for the addition to be rented out to the "structure" portion. Then I will allocate 33% of my land value to the "land" portion. 33% of the land value is $10K. So on my rental when entering it into the TurboTax program in the "COST" box I will enter $60K and in the "COST OF LAND" box I will enter $10K.

Got it? If not I'll try my best to explain it better. This will be tricky for you because you are renting out "A part of" your primary residence and it will be very, very easy to get confused without even realizing you're confused. Especially when you get to the allocation of property taxes, mortgage interest and the such.

If you have a separate mortgage that is for the addition only, and if you get a separate 1098 - Mortgage Interest Statement for that loan, then it's all deductible. But the property taxes will be a different story since those will have to be split between the SCH E for the rental portion and SCH A for the primary residence portion. The split is based on percentage of property that is actually allocated to the rental (including the percentage of land). That means some manual math on your part, as the TTX program can only do so much.

I've been doing "the rental property thing" for going on 30 years now and have learned a lot of lessons the hard (and c ostly) way. It's my hope to help others such as yourself avoid the pitfalls that at times almost consumed me. Now here's that additional information I promised.

Rental Property Dates & Numbers That Matter.

Date of Conversion - If this was your primary residence before, then this date is the day AFTER  you moved out.
In Service Date - This is the date a renter "could" have moved in. Usually, this date is the day you put the FOR RENT sign in the front yard.
Number of days Rented - the day count for this starts from the first day a renter "could" have moved in. That should be your "in service" date if you were asked for that. Vacant periods between renters count also PROVIDED you did not live in the house for one single day during said period of vacancy.
Days of Personal Use - This number will be a big fat ZERO. Read the screen. It's asking for the number of days you lived in the property AFTER you converted it to a rental. I seriously doubt (though it is possible) that you lived in the house (or space, if renting a part of your home) as your primary residence or 2nd home, after you converted it to a rental.
Business Use Percentage. 100%. I'll put that in words so there's no doubt I didn't make a typo here. One Hundred Percent. After you converted this property or space to rental use, it was one hundred percent business use. What you used it for prior to the date of conversion doesn't count.

This has been super helpful @Carl ! I totally understand what you’re saying.

In essence, the structure cost will be the cost of my ADU. Your “cost” is $50k(?). I think you said $60k in your previous post but I think you meant $50k?

For the land, since your ADU added additional 1000 sq ft to your house, it’s 33% of your total sq ft, therefore, it’s $10k from your original $30k. So your “Cost of land” is $30k.

im assuming when you entered this ADU as a rental, it’s a single family unit and not a multi family. 

Your “cost” is $50k(?). I think you said $60k in your previous post but I think you meant $50k?

No. I specifically meant sixty thousand dollars in my example. What goes in the "COST" box includes the value of the structure *AND* the land. So in my example that's $60K, not $50K.

Then in the "COST OF LAND" box it's $10K. The program will "do the math" in the background and assign $50K to the structure and that $50K is what gets depreciated over the next 27.5 years. Remember, land is *never* depreciable.

So your “Cost of land” is $30k.

Again, no. You are not allocating 100% of the land to the rental. Only 33%. Therefore the cost of land in my example would be $10K.

Now that's just "my" way of doing this. There is another way to do this and I suspect you are confusing yourself with that "other way". Could this be the case? If so, would you like me to cover that "other way" also, in the chance that may be the way you're thinking? (Both ways are legal, but may not result in the same "bottom line number" for depreciation as the end result

@Carl ,

Sorry I'm a bit slow when it comes to this, but I had to read your post a couple of times to understand the "COST" and "COST OF LAND" that you wrote in your thread.

If you don't mind sharing the other way to calculate this, I'm interested in learning it. The more I learn about this, the more helpful it becomes when tax time comes. I think I'll go ahead and plug in some numbers to see how it works out. Thank you in advance for all your help @Carl !

For the other way, lets consider some realistic numbers based on a longer timeframe.

I purchased my house in 1990 at a cost of $35,000. The house occupies 1,500 sq feet and sits on a lot that is plenty big enough for me to add on to. Let's say 1/3 of an acre. Now of that $35K I paid for the house $28K is what I paid for the structure and $7K for the land. The structure is 3 bedroom, 2 bath, kitchen, dining room and living room. My "cost basis" on the property is $35K at this point.

Now in 2015 I add on another 1,000 sq ft consisting of a kitchenette, bedroom, bath and a laundry room. The addition cost me $50,000. Now by total square footage of my structure is 2,500 sq feet and my total cost basis in the property is $85K with $78K paid for the structure and $7K for the land. (I didn't pay squat for more land... I only paid for more structure.)

If I'm going to rent out what I added on then I figure what percentage of what is basically my primary residence floor space I am going to use for this rental business. I'm renting out 1000 sq feet of my total 2500 sq feet of my structure. 1000/2500=0.4 or 40% of my floorspace.

So in the rental & royalty section of the program I will indicate that "I rent out a part of my primary residence". Then when I get to that point I will enter $85,000 in the "COST" box and $7,000 in the "COST OF LAND" box. I will also indicate the entire property is 40% business use. THe program will do the additional math "for me" in the background and not bother me with the details. Basically, here's how it will work out.

Since land is never depreciable, it doesn't figure into the equation really - even though the program will assign 40% of the $7,000 land value to the rental portion. That comes to $2,800 and the only place you'll see that will be in the IRS Form 4562 that prints in landscape format. (There are two of these forms - one titled "Depreciation and Amortization Report" and the other is titled "Alternative Minimum Tax Depreciation Report")

Then 40% of the structure value will be $78,000 X 0.4 = $31,200 and that is the amount that will be depreciated over the next 27.5 years.

Now whichever way you do this really doesn't matter. But just remember that in the end, what you save in taxes now, you will pay back later, and the payback later will be more than what you may save now.

When you sell the property down the road, all prior depreciation must be recaptured in the year of sale, and you pay taxes on that recaptured depreciation. Now while chances are good that your carry over losses will negate a large portion of that, it all depends on your sale price (thus your taxable gain on the sale). But regardless, the recaptured depreciation *will* increase your AGI for that year and when combined with the taxable gain will most likely put you in a higher tax bracket.

So you can save now, pay later if you like. Or you can save less now and potentially pay less later.

Oh, one other thing too. It's not like you learn this stuff through osmosis. I certainly didn't. So please don't hesitate to ask more questions. The only stupid question is the one you didn't ask, or forgot to ask. I learned over 90% of what I know dealing with rental property, in the school of hard knocks. So if possible I like to help others learn in the school of experience. You know that school... been there... done that... got the T-Shirt!

You will only enter the new construction asset in the program and ignore the land value since it is not depreciated anyway ... this will make the entry easier by putting in a zero for the land value ... 100% of the land value should remain with the personal residence.

Hi Carl,

Can you please run through how you would allocate property taxes and mortgage interest on an rental ADU that is located on the same property as your primary residence?  Thank you. 

@Wtajason for the benefit of others reading this thread, take note that your post is what we call an "add-on". In other words, the details provided in this thread by the original poster may not be "your" details. So I'm not willing to risk making incorrect assumptions which will result in the waste of time for both of us. I ask that you please start a new thread of your own explaining your specific situation. Here's some details you "must" provide to save time as well as reduce the possibility of the reader making incorrect assumptions.

-  Does each unit have a physically separate mailing address? (if an address such as 201A for your residence, and 201B for the rental, then that's a physically separate mailing address.)

 - Are utilities (electric, water, etc.) metered separately?

 - Do you have one single mortgage for all structures on the land? If more than one mortgage, then what does each mortgage cover? (I would expect only one to include the price of the land - but expectations can be wrong too.)

 - How is property taxes handled? One property tax bill each year for the land and all structures on it? Or are property taxes billed separately for each structure?

 - What about the property insurance? This is a biggie. Homeowner's insurance does "NOT" cover rental property or any other type of business property. If you have two structures on the land with one of them as your primary residence, then thats covered by homeowner's insurance. If the other structure is a rental, then that has to be covered by what is referred to as a "Rental Dwelling Policy". If you file a claim against your homeowner's policy for something on the rental property, then the insurance company can (and will) deny your claim because the property was not being used for it's insured purpose. This can cause your problems to balloon even bigger when the mortgage holder finds out. So the homeowner's policy covers only your primary residence, and you need a physically separate policy for the rental unit.

Generally, the rental dwelling property will come with an absolute minimum of $300K of liability insurance and will cover only that which you own (namely, the structure, appliances, etc.) It does NOT cover what a tenant owns that may be lost in a fire or other disaster. That's why I state this fact in my rental contracts and advise the renter to purchase their own "renters policy" to insure their property. This way the renter can't come after me if they lose their property in a disaster that covers *me* in my own rental policy.

Hi,

Question about your homeowner’s insurance statements.  My insurance company told me that my policy does in fact cover the new, detached, ADU we built on our property.  Is that something that varies by company then?  Your statement sounds certain the rental property would not be covered.  Are there specific additional questions I should be asking / terminology I should be using if I go back to my insurance company to verify what they told me?  I had assumed before speaking with them that I needed a separate policy of some sort but they said no, because of some part of the policy which I’m forgetting the name of, possibly “other structures coverage”?  Thoughts?

[Information added from Super User Carl 4:55 am 4-4-17 PS...@Carl 

Your tips have been SOO informative.  I'm converted my garage into a separate ADU as well and will use your instructions to account for the cost of building, inspections, architect charges, etc.

Any tips you can provide as I dive into this uncharted territory...

The cost to build your ADU will be treated as a capital improvement to your property the same as if it were actually attached to the current dwelling on the property.  As such the expense to build the ADU will be the cost basis of the ADU used for depreciation.  The ADU should have its own depreciation schedule seperate from the existing dwelling on the property.

I have something KIND OF related...I’m renting the “main house” - a single family unit. I’ve been renting for 8 years. In my lease, I have access/use age rights to parking, Front/Backyard garden, the garage and, obviously, the house. 

My landlord started construction on an ADU on the property I am renting. I have about 10% of the backyard now;  it was a garage conversion, so that’s gone, as well; and no more access to the driveway. The construction company has been wrecking my property and not even bothering to post a permit (until I asked), or even tarp areas off when they work.

The ADU is so big - the design has left me with no privacy. Anyone in the ADU has a floor to ceiling view of my room/bathroom...etc. it’s a nightmare.

I have renters insurance - I’m not sure what he has for the property. I guess I’m wondering if anyone knows if this is legal? I received NO written notice of the project - still haven’t and it’s 3 months in. It’s considered an ADU (garage conversion) and a home improvement ...but it’s being built on the Property I currently rent.

Would my loss of use of the items in my lease that were taken away constitute a rent reduction? By what percent!? Do I need to ask for a property assessment? 

PS he has not lived in the house ever. The ADU is being built by his trust (so unlike my lease, which is in his name, the ADU is in the trust’s name). I know I’m not “entitled” to the parking I lost, but surely there is something I can do for the loss of the garage and yard? I’m paying $300 a month more for a storage unit, too! 😕 

I don’t know how I’d handle this or if it’s something I can get him to deal with as a write off or whatever. He is likely going to evict me, even though I’m living here during construction - which, again, is a nightmare. Any advice will help! Thanks! 

Thank you for all the info. Could you give me some guidance? I’m building an adu and thinking I would move into the Adu and rent out my primary. Will the interest on my mortgage be deductible anymore? How do I go about depreciating part of the house (adu vs main house) 

@Vanjngo If you rent out your main home, you can deduct all expenses (including Mortgage Interest, Property Tax, Insurance, etc.) as well as Depreciation.

Click this link for more info on Claiming Rental Income and Expenses. 

Hi, this is in interesting topic and thank you for the major contribution from @Carl

I am also building a detached ADU for rental purpose in my primary residence like @Dtee  is/was doing. I started the official process in early 2020 during which I started paying for architecture/structural drawing along with permit fee etc.. So the construction expense started in year 2020.
This ADU will be in service in the middle of 2021

For the current tax filing for year 2020, (the ADU is not in service yet in 2020), will I be able to deduct any of these expense?
I read about startup expense, are the startup expense($5000) only deductible IN the first year of service? (in my case that would be year 2021)
I am wondering if there is any deduction I can take in tax year 2020.
many thanks

Frank

For the current tax filing for year 2020, (the ADU is not in service yet in 2020), will I be able to deduct any of these expense?

No. Your total cost from conception to completion will be your cost basis for the ADU and is the amount that will be depreciated over 27.5 years starting on the date you place the ADU "in service" as a rental property.

I read about startup expense, are the startup expense($5000) only deductible IN the first year of service? (in my case that would be year 2021)

Start up expenses are not permitted for SCH E residential rental real estate. That's only for a SCH C business. Your cost of "preparing the property for rent" for that very first tenant are flat out not deductible at all unfortunately.  Besides, I seriously doubt you would have any such expenses since this will be new construction.  Your biggest issue is going to be dealing with the conversion of the construction loan, to a mortgage loan. I myself am not at all familiar with how to deal with that. All I'm aware of on that front is in IRS publication 936 at https://www.irs.gov/pub/irs-pdf/p936.pdf on page 4 under "Home under construction".  But that's for a "qualified home". Since you intend to rent it out from the start, I don't know if that negates it being a qualified home or not.

Question about your homeowner’s insurance statements. My insurance company told me that my policy does in fact cover the new, detached, ADU we built on our property. Is that something that varies by company then?

Things can vary by insurance company.  The main thing I see where insurance does not pay out on a loss, is when the insured property is not being used for it's insured purpose. So if the property is insured as your primary residence or 2nd home, but you are using it to generate income, then it's not being used for it's insured purpose. You basically have to read your policy from the insurance provider's point of view, and if you find a legal loophole that would enable them to deny a claim, you need to get with your agent and fix that loophole.

if I go back to my insurance company to verify what they told me?

What you're told verbally can hold very little (if any) weight in the legal system. It's a "he said she said" situation, and what's in writing in your policy is all that matters. Insurance companies have a team a lawyers. You don't. Get it in writing.

Insurance companies don't make their profit by selling policies per-se. They make it by denying claims on any legal ground they can grab hold of.

Hi Carl,

Thank you @Carl for the very clear answer. I think i will forget that startup cost deduction.

As a practice, I pretend the ADU is put in service on July 1st 2020 and added the ADU to my 2020 tax return to see what I can deduct. I followed your advice to treat the ADU as a "unit in a duplex".

Using square footage, I counted the rental percentage as 40% of the entire real estate (Primary Residence + ADU)
For this ADU, I added the LAND COST to be $A. The COST to be $A+$B. As you predicted the 2020 rental depreciation is $B/27.5 * 0.5. where the 0.5 comes from being in service for half a year. so this makes sense.

Question 1: Please tell me if my assumption is correct that the tax law allow me to deduct 40% of the property tax, mortgage interest and insurance for the entire real estate(Primary residence + ADU) as the ADU expense.

(please let that be YES =p)

(Here comes my question)
With that assumption, I entered all the expense such as the property tax($16K), mortgage interest($12K) and insurance($2K). Since turbo tax will be doing the partition for me using that 40% number, It asked me to enter the total amount. This total amount is what the ADU+Primary Residence see FOR THE WHOLE YEAR = $30K. What turbo tax did is to take $30K * 40% = $12K and call that the expense for the ADU. But it didnot account for the half a year of in service time. For the first year, this is tricky

Question 2: How should i do this? Should I
take half of property tax and put $8K in ADU and $8K in primary =>(enter $8K only for primary real estate tax)
take half of mortgage interest and put $6K in ADU and $6K in primary =>(change mortgage interest 1098 entry to half)
take half of hazard insurance and put $1K in ADU and $1K in primary =>(none entered for primary house insurance any way)?

or are there better ways

Question 3: I imagine this is not a problem when the ADU is rented for an entire year so i can just enter 100% into turbo tax and let it use the 40% multiplier. This is assuming the answer to Question 1 is YES.

thank you so much for patiently helping us newbie.

Hi@Dtee ; were you able to deduct a portion of your total property tax/mortgage interest as the ADU expense when the ADU is rented while you live in your primary residence?  thank you.

Frank

this is tricky

There's programming limitations in the program where for "your" "specific" "situation" you are not being asked the right question at the right time. Basically, you're asked "Percentage of time the property was rental during the year (e.g.;80%)"  That's the wrong question for *your* situation. The question should be asking percentage of floor space. Not percentage of time. But if you treat the unit for what it is (a physically separate structure that is single family housing) you won't have to deal with remembering this every year.

Overall, because the ADU is new construction, I recommend you treat the ADU as it's own physically separate single family rental unit. It will make your life simpler down the road if/when you sell the property.  In other words, using your numbers the property is it's own single family unit with it's cost basis being the cost of construction, plus 40% of the land value.  Everything is 100% business use.

Then the only math you have to do is 40% of the property taxes, mortgage interest and property insurance. That's it.

Get the utilities metered separately. Otherwise, there are two possible and acceptable ways to split the utilities. It can get complicated on this front with utilities if you have periods of personal use/vacancy. But not an issue of the utilities are metered separately.