Understanding ADUs and Taxes: Impact on Property Taxes and Tax Deductions in California

California, a state known for its diverse culture and vibrant cities, is also infamous for its high real estate prices and rising property taxes. Over the past few years, homeowners in California have tried various strategies to reduce their taxes. One such strategy gaining popularity is the construction of Accessory Dwelling Units (ADUs). 

Along with the additional living space, ADUs can increase your property’s value and save you money on taxes in California.

This comprehensive guide discusses the relationship between ADUs and taxes, providing a detailed understanding of how this secondary unit can impact your finances and tax situation. Based on this, you can decide whether adding an ADU to your property is a good option or not.

Does Adding an ADU Increase Property Taxes in California?

Yes, adding an ADU to a property generally increases the property taxes. However, adding this secondary unit will not affect the taxes on the primary living space. There will be no reassessment of the taxes on the main unit of the property. Read more to learn about the full tax implications of adding an ADU to your property.

How is Property Tax Calculated for an ADU in California?

When you add an ADU to your property, the assessor will add the value of the ADU to the existing value. This process is called blended assessment. The primary house is not reassessed, so the original tax value will remain the same, with an addition of ADUs tax value.  

How Much Does an ADU Increase Property Taxes in California?

Property tax rates on ADUs in California generally range from 1-1.5% of the construction cost. For example, if the construction cost of an ADU is $300K, you might expect to pay around $3,000 as additional property taxes per year. You may consult with a tax professional to get an accurate estimate of the impact of adding an ADU on your property taxes, as this may vary depending on your specific situation.

In California, the property value of an ADU is assessed at market value as of the date of completion. 

When is the Value of an ADU Added to the Property Taxes?

All cities and counties must inform the County Assessor’s Office whenever they issue building permits. Once the assessor’s office reassesses the value of a new construction, the property owner receives a letter with a new property assessment. As the changes are reflected in the next regular property tax bill, it may take up to a year for the new assessment tax to become active.

Under California law, the assessor’s office must appraise all constructions as of January 1st to evaluate their value for property tax assessment. This value is then shown on the next property tax bill you receive. You can appeal the value if you disagree with the new assessment.

How Will Building an ADU Affect Personal Taxes in California?

Adding an ADU will increase the value of your property, increasing the overall property taxes. Just building an ADU may not affect your taxes. The property taxes are based on the assessed value of your property as of January 1st every year. So, if you build an ADU after this date, the property tax will not increase until the following year. And, if you use your ADU wisely, like renting it out or using it as office space, you might qualify for yearly tax deductions and credits. 

How to Deduct the Cost of the ADU From Taxes?

When you sell your property, you are subjected to capital gains taxes like any home. However, if this property is your primary residence, you may be able to save up to $250,000 if you are single and $500,000 if you are married and filing jointly your capital gains from taxes.

This means you would get a tax shelter when selling a property with an ADU, unlike a separate investment property that does not count as a primary residence. This is one of the many reasons why investors choose an ADU for investment.

Your profit on the sale is calculated by subtracting the selling costs and tax basis from the home’s selling price. Now, what exactly is the tax basis? It is the sum of the original purchase price, purchase-related expenses, and the cost of upgrades (such as building an ADU) minus depreciation and insurance payments.

Is It Possible to Write Off an ADU From Personal Taxes Every Year in California?

Only building an ADU will not impact your tax situation. The value of your property and its potential to earn from the ADU, however, will affect your taxes. This is because an ADU is considered a part of your earnings. 

In case you run a small business out of your newly constructed ADU, you may be able to deduct the depreciation and the cost of construction, along with the other expenses associated with improvement.

When you eventually decide to sell your property, you will have an opportunity to account for the construction costs of the ADU. Still, you will need to pay capital gains tax on the increased value of the property.  

Even though taxes can sometimes feel burdensome, it is important to remember that they are used to fund necessary community services, such as new roads and better schools. 

Importance of Informing Homeowners’ Insurance Company for Adding an ADU

As a homeowner, you should contact your insurance provider to discuss and understand how an ADU will affect your existing policy. Standard homeowners insurance usually does not cover renovations or any new construction. Before initiating the construction work of an ADU, you should adjust your policy to ensure that every new unit of your property is covered. However, the amount of coverage required will depend on the size and market value of the project. The insurance provider will not pay for any damage to an ADU unless it is specifically covered under the policy.

ADU Tax Benefits

While you have an additional tax added to your property tax with the construction ADU, it comes with some major tax benefits:

1. If you rent out the ADU, you will likely reimburse the additional tax cost within a few months. 
2. Some cities and states have specific tax incentives for adding an ADU to your property.
3. You can profit from tax advantage on other things like mortgage interest, property repair, or advertising the rental.

How Can BFPM Help You Understand ADU and Taxes in California?

Our BFPM property managers stay up-to-date on the latest ADU laws and regulations in California so that you can get accurate information. We also assess your property to determine if it meets the requirements for an ADU. Further, we will help you navigate the permission process and advise you on the tax implications of constructing and renting your ADU.

Feel free to contact BFPM for the construction of a new ADU on your existing property. We are here to help you.

Read our related blogs:

ADU Financing Options in California