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?

[jneane]

[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...

[LeonardS]

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.

[DanaJ720]

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! 

[Vanjngo]

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) 

[MarilynG1]

@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. 

[potsticker]

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

[Carl]

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.

[Carl]

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.

[potsticker]

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

[Carl]

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.