ADU taxes: what building and renting a backyard unit means

By Tom, CPA · Updated October 27, 2026

Part of: Rental Property Taxes

TL;DR: An accessory dwelling unit (ADU) you rent out is a separate rental. Its construction cost is capitalized and depreciated over 27.5 years from the day it's ready to rent. Your property tax bill usually rises by the value added. When you sell, a detached ADU's share of gain is generally not covered by the home sale exclusion, and depreciation is always taxed.

Educational only, not tax, legal, or investment advice. Examples are illustrations, not predictions. Rules and limits change; verify current figures and talk to a qualified professional about your situation.

An ADU is a second, independent home on your lot. It might be a backyard cottage, a converted garage, or a basement apartment with its own kitchen and entrance. They're popular because the land is already paid for and the rent can be meaningful. Your tenant pays the construction loan; the IRS pays for the build (eventually, over 27.5 years). Here's the tax picture, from permit to sale.

CPA Warning Label: A rented ADU's gain isn't covered by the home sale exclusion, and depreciation is always taxed. Construction-period interest may need to be capitalized, so confirm with a tax professional.

Property tax reassessment

Adding an ADU almost always raises your property tax, but how much depends on your state and county. Common patterns:

• Value-added assessment. Many places, including California under Proposition 13's new-construction rules, add the assessed value of the new construction to your existing base, without reassessing the whole property.
• Full market reassessment. In states that reassess regularly at market value, the ADU's contribution simply shows up in the next assessment.
• Exemptions and caps. Homestead exemptions usually cover only your residence, not the rental portion. Some places offer ADU incentives.

Check with your county assessor before you build so the higher tax goes into your rent math. For federal purposes, the ADU's share of property tax is a rental expense on Schedule E, not subject to the SALT cap. The share for your main home stays on Schedule A if you itemize. The ADU's share can be split using the assessor's breakdown, which is the cleanest method, or square footage.

Depreciating ADU construction

Construction costs aren't deducted when paid. They're capitalized into the ADU's basis and depreciated once the unit is placed in service, meaning ready and available for rent, not necessarily rented. What goes into basis:

• Contractor and materials costs, permits, impact and utility connection fees, architect and engineering fees.
• Site work tied to the building, such as foundations and utility trenches.
• Construction-period interest and property taxes may need to be capitalized under section 263A(f) for self-constructed property, though small taxpayers may be exempt. This is a point to confirm with your preparer.

Land isn't depreciable, and you already own it, so none of the land basis moves. Residential rental property is depreciated straight line over 27.5 years with the mid-month convention (Pub. 946). Some ADU parts, such as appliances, furniture and certain land improvements, may qualify for shorter lives and bonus depreciation, which is 100% for property acquired after January 19, 2025 as of Oct 2026 (IR-2026-06). A cost segregation study is rarely worth the fee for a small ADU. See the depreciation guide.

Section 121 complications

The home sale exclusion covers your principal residence. Under Treas. Reg. 1.121-1(e), if part of the property is a separate dwelling unit used as a rental, you allocate the basis and sale price between your home and that unit. The unit's gain is taxable. A detached ADU with its own kitchen, bathroom and entrance is generally a separate dwelling unit. An in-house apartment can be too.

So when you sell, expect three pieces:

1. Your home's gain, excluded up to $250,000 single or $500,000 joint if you meet the 2-of-5-year tests.
2. The ADU's gain, taxed as long-term capital gain.
3. All depreciation, taxed as unrecaptured section 1250 gain at up to 25%.

A 1031 exchange of the ADU portion is possible in theory, but it's awkward when the main house sells with it. If you lived in the ADU for 2 of the 5 years and rented the main house, the analysis flips. See house hacking taxes and combining 1031 and 121.

Financing interest

How you finance the ADU changes where the interest goes:

• Home equity loan, HELOC or cash-out refinance secured by your home. Under interest tracing rules (Treas. Reg. 1.163-8T), interest follows the use of the money. Money spent building a rental unit means the interest is a rental expense on Schedule E, even though the loan is secured by your house.
• Construction loan for the ADU only. Same answer. The interest is a rental expense once the unit is in service. Interest during construction may need to be capitalized (see above).
• Mixed use. If you use part of a HELOC for the ADU and part for a car, trace each draw. Keep separate draws and records.

Loan points on a rental loan are amortized over the loan's life, not deducted up front. See cash-out refinance taxes.

Example

Illustration (made-up numbers): Frugal Fran builds a detached ADU in her backyard for $200,000, financed with a $200,000 HELOC at 7.5%. It's placed in service on July 1. Rent is $2,200 a month. Her county adds $200,000 to her assessed value, raising her tax by $2,400 a year.

She collected $26,400 and spent $19,400 in cash, but her taxable rental income is about zero. That's depreciation at work. Her cash flow is about $7,000 a year, and she still owes principal on the HELOC.

Ten full years of depreciation later, she sells the whole property for $1,100,000. An appraisal allocates $250,000 of the price to the ADU. Its adjusted basis is about $200,000 minus about $72,700 of depreciation, which is about $127,300. The ADU gain is about $122,700: about $72,700 taxed at up to 25%, and about $50,000 at long-term capital gain rates. Her home's gain is excluded under section 121 if she qualifies. Lavish Larry, who built the same ADU and "just put the whole sale under the exclusion," will learn about Reg. 1.121-1(e) from a letter.

Before you build: a tax checklist

1. Ask the assessor how the ADU will be assessed and whether any exemption or incentive applies. Put the higher property tax into your rent math.
2. Pick the financing with tracing in mind. Draw HELOC funds into a separate account used only for construction, so the paper trail is obvious.
3. Keep a construction file. Save every invoice, permit fee and draw statement. This becomes your depreciable basis, and you'll need it again on sale.
4. Separate land improvements and personal property. A new driveway or fence (15-year property) and appliances (5-year) can be listed separately from the 27.5-year building.
5. Record the placed-in-service date. Photos of the finished unit, the certificate of occupancy and the first listing date work well.
6. Get a value split on sale. An appraisal that allocates price between the house and ADU is much stronger than a guess.
7. Plan the long game. If you'll sell within a few years, depreciation recapture and the taxable ADU gain may make the after-tax return smaller than expected. Run it through after-tax cash-on-cash before you break ground.

Other ADU tax points

• Renting to family. Below-market rent to a relative makes the ADU personal-use under section 280A, so you can't deduct a loss. Charge fair rent if you want rental treatment.
• Passive loss limits. ADU losses are passive. With active participation and AGI under $100,000, up to $25,000 can offset other income, phasing out by $150,000.
• Short-term rental. If the ADU is a short-term rental with an average stay of 7 days or less, different passive and possibly self-employment rules apply. See the short-term rental tax guide.
• Living in the ADU yourself. If you move into the ADU and rent the main house, the rental share flips, and so does your depreciation base.
• State credits and grants. Some state or city ADU grants may be taxable or may reduce basis. Check the program's tax guidance.