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 have is the added property taxes.
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.
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). Over a 12-month period the tax would only be $83 per month. Given the potential rent you could collect, whether $1,200 or $2,200 a month that would be more than enough to justify the added property taxes; 14 times more than enough.
Protecting yourself and other benefits
Consider wrapping your ADU in a Limited Liability Company (LLC). If a mishap were to happen with your ADU renter, 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 is allowed to be depreciated over 27.5 years, starting the month the ADU becomes available for rent. You begin writing off the 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), you get to recognize the depreciation expense. If your ADU cost is $100,000 and assuming it was available for rent January 1 then the first year's depreciation would be $3,485 ([$100,000 / 27.5 years] x [11.5 / 12] = $3,485.85)
LLCs are disregarded for tax purposes whether you're married or not. 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 are many considerations about building an ADU. Information is available, 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 expenses to pull permits, all the different contractors and inspections involved. As of the date of this blog, there is only one company that has completely streamlined the entire process from taking your ideas to designing plans, pulling permits, building, and then renting your ADU.
Give them a call 619-588-4346 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 they're also a way to create immediate equity. Stay tuned for my next blog about ADUs and how they're a guaranteed way to generate instant equity. Homeowners cannot afford to not 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.