Real Estate Tax Calc
The incremental cash-on-cash framework
An ADU (accessory dwelling unit) is typically a garage conversion, basement apartment, detached backyard unit, or attached addition. The return analysis treats the ADU as an incremental investment:
Cash invested = construction cost (all in: design, permits, construction, landscaping, appliances). Typical range: $80,000–$250,000+ depending on type and location.
Annual cash flow = gross rent − vacancy − operating expenses (insurance, utilities, maintenance allocation, property management if applicable). Do not include mortgage on the main property — the ADU sits on existing debt.
Incremental cash-on-cash return = annual cash flow ÷ construction cost. A $120,000 garage conversion generating $1,500/month net ($18,000/year) produces a 15% cash-on-cash return — higher than buying a separate property at current prices in many markets.
Depreciation on an ADU
If the ADU is part of your primary residence (e.g., a basement unit), you must allocate the basis between residential personal use and rental use. Only the rental portion is depreciable.
For a detached ADU constructed on a rental property: the full construction cost (less any land portion) is depreciable as a separate structure. The recovery period is 27.5 years (residential rental).
For a detached ADU at your primary home: the portion used for rental is a separate rental property for tax purposes, depreciating over 27.5 years. When you sell the main house, the Section 121 exclusion applies only to the personal-use portion; the rental ADU portion may generate depreciation recapture.
Practical considerations before you build
Local permitting and zoning: many jurisdictions have ADU-friendly laws that streamlined permitting, but confirm your municipality allows the type of ADU you want. Permits affect the placed-in-service date (when depreciation starts).
Financing: construction costs may be funded by a HELOC, cash-out refinance, or construction loan. The interest on a loan used to build a rental ADU is deductible as a rental expense (mortgage interest tracing rules apply).
Upside and risk: an ADU typically adds value to the property (increasing appreciation), but construction overruns are common. Budget a 15–20% contingency. The return analysis should use conservative rent estimates and include a vacancy assumption even in tight markets.
A worked example: a $150,000 detached ADU
Suppose you build a detached 700-square-foot ADU in the backyard of a primary residence. All-in cost, including design, permits, site work, utility hookups, and appliances, comes to $150,000, funded with a $120,000 HELOC at 7.5% interest and $30,000 cash. You rent it for $2,100/month.
Cash flow. Gross rent is $25,200/year. Assume 5% vacancy ($1,260), insurance and increased property tax of $1,800, utilities and maintenance of $2,400, and no professional management. Operating cash flow before debt service is roughly $19,740. HELOC interest in year one runs about $9,000, leaving net cash flow of about $10,740.
Cash-on-cash return = $10,740 ÷ $30,000 cash invested = 35.8% on the out-of-pocket cash, because most of the project is financed. On the full $150,000 project cost, the unleveraged yield is $19,740 ÷ $150,000 = 13.2%. Both figures are useful: the leveraged number shows the return on your actual cash, while the unleveraged number shows the quality of the asset itself, independent of financing.
The tax layer. Depreciation of roughly $5,455/year (see below) plus the $9,000 of deductible interest and $6,000-ish of other operating expenses often produces a tax loss on paper even while the ADU generates positive cash. That loss may be limited by the passive activity rules discussed further down.
Setting up depreciation: basis, land, and placed-in-service
For a newly constructed detached ADU, your depreciable basis is the construction cost — you do not allocate any of it to land, because the land was already owned and its cost stays in the land account, which is never depreciated. So a $150,000 ADU gives you a $150,000 depreciable basis (subtract the cost of any land improvements like a separate driveway, which depreciate over 15 years rather than 27.5).
Residential rental property is depreciated straight-line over 27.5 years using the mid-month convention (IRS Publication 527; Form 4562). At $150,000 ÷ 27.5, the full-year deduction is about $5,455. The first year is prorated from the middle of the month the ADU is placed in service — meaning ready and available to rent, not the month a tenant actually moves in. Advertising the unit as available is generally enough to start the clock.
If instead the ADU is carved out of your existing home (a basement or attached conversion), you allocate your home's basis between personal and rental use, typically by square footage, and depreciate only the rental share. Improvements made specifically for the rental (a separate kitchen, egress windows) are added fully to the rental basis.
Section 121 and depreciation recapture when you sell
A detached, separately metered ADU that you never lived in is treated as business property. When you sell the whole parcel, you allocate the sale price between the main home (eligible for the Section 121 exclusion of up to $250,000 single / $500,000 married filing jointly) and the ADU (not eligible, because it was not your residence).
Regardless of Section 121, all depreciation you claimed (or were allowed to claim) on the ADU is subject to unrecaptured Section 1250 gain, taxed at a maximum federal rate of 25%. This applies even to the personal-residence portion if you depreciated space within the dwelling. Keep a running depreciation schedule so this figure is not a surprise at closing.
Example: you claimed $27,275 of ADU depreciation over five years, then sell. Even if your overall gain is small, up to $27,275 of it is taxed as unrecaptured 1250 gain at up to 25%, and the balance of the ADU-allocated gain is long-term capital gain. A 1031 exchange of the ADU-attributable portion is theoretically possible but complex when the ADU shares a parcel with your home.
Passive losses, the $25,000 allowance, and material participation
Rental real estate is passive by default under Section 469, so a paper loss from your ADU generally offsets only passive income, not your wages. The main relief valve is the $25,000 special allowance: if you actively participate (make management decisions like approving tenants and setting rent) and your modified adjusted gross income is $100,000 or less, you can deduct up to $25,000 of rental losses against ordinary income. The allowance phases out between $100,000 and $150,000 of MAGI.
Losses you cannot use are suspended and carried forward on Form 8582, freeing up when you have passive income or when you fully dispose of the ADU in a taxable sale. Real estate professionals (750+ hours and more than half of personal service time in real property trades) can treat the activity as non-passive, but few ADU owners meet that bar.
For most homeowner-landlords, the practical takeaway is that the ADU's cash flow is real and spendable, while a portion of its tax deductions may be deferred rather than lost.
Common mistakes ADU owners make
Ignoring the land allocation on a conversion. When the ADU is inside or attached to the main home, failing to allocate basis correctly either over- or under-states depreciation and creates recapture headaches at sale.
Counting the main-property mortgage against the ADU. The ADU sits on debt you already had. Including that mortgage in the ADU's return analysis understates the incremental yield and leads to bad build/no-build decisions.
Deducting the construction cost as a repair. Building an ADU is a capital improvement — it must be capitalized and depreciated, not expensed. Only ongoing repairs after it is in service are current deductions.
Forgetting the increased property tax and insurance. Adding livable square footage usually triggers a reassessment and higher premiums. Model these before you build, not after.
State tax and local rules that shape the return
State income tax stacks on top of the federal picture. In a high-tax state, rental income and any depreciation recapture at sale are taxed again at the state level, so the true after-tax yield on an ADU is lower than the federal-only math suggests. In no-income-tax states, the state layer disappears but property-tax reassessment can be sharper.
Property tax treatment varies widely. Some jurisdictions reassess only the added value of the ADU; others, under assessment-cap regimes, may reassess the improvement without disturbing the base parcel's capped value. A few localities offer ADU incentives or fee waivers that improve the return. Confirm how your assessor treats new livable square footage before you finalize the budget.
Finally, rent-control and local registration rules can cap the rent you can charge and impose fees that reduce net cash flow. These are not federal tax items, but they change the numerator in the cash-on-cash calculation and should be modeled alongside the tax analysis.
Frequently asked questions
Is an ADU eligible for depreciation?
Yes. The construction cost of an ADU used for rental is depreciable over 27.5 years as residential rental property. If part of your primary home, only the rental portion is depreciable.
What is a good cash-on-cash return on an ADU?
ADUs in high-cost markets often pencil at 8–15% because construction is cheaper relative to local rent levels. Below 6% starts to look weak relative to alternatives.
Does adding an ADU affect my Section 121 exclusion?
It can. The rental-use portion of your home — including a rented ADU — may generate depreciation recapture not sheltered by the Section 121 exclusion when you sell.
When does depreciation on my ADU start?
On the placed-in-service date — the month the unit is ready and available to rent, which you can establish by advertising it. That is often earlier than the date your first tenant moves in, and the first year is prorated using the mid-month convention.
Can I deduct the HELOC interest I used to build the ADU?
Yes. Under the interest tracing rules, interest on debt whose proceeds were used to build or improve a rental unit is deductible as a rental expense on Schedule E, regardless of what property secures the loan. Keep records showing the loan proceeds funded the ADU.
Can I write off the whole ADU in the year I build it?
No. Constructing an ADU is a capital improvement that must be capitalized and depreciated over 27.5 years. Bonus depreciation and Section 179 do not apply to the building structure itself, though shorter-lived components (appliances, certain land improvements) identified in a cost segregation study may qualify.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.