ADU Tax Deductions: Depreciation, Passive Loss Rules, and Recapture

The tax deductions available on an accessory dwelling unit depend almost entirely on how you use it. An ADU rented to a tenant at fair market rent unlocks the full landlord toolkit: operating expenses, depreciation over 27.5 years, first-year bonus depreciation on certain components, a potential $25,000 offset against your other income, and a 20% qualified business income deduction on top of all of that. An ADU occupied by a family member who doesn’t pay rent gets you nothing beyond the mortgage interest and property taxes you already claim. Everything below assumes you’re renting; the first section explains how the IRS decides which bucket you’re in.

How the IRS Classifies Your ADU

Section 280A of the Internal Revenue Code sorts your ADU using two numbers: days rented at fair market value, and days used personally. The classification determines which deductions you can take and whether a loss can offset your wages.¹

Pure rental. The unit is rented 15 or more days, and your personal use doesn’t exceed the greater of 14 days or 10% of the rental days. Rent it 200 days and you can use it personally for up to 20. This category gives you access to every deduction described in this article, including the ability to generate a deductible loss.

Mixed use. Rented 15 or more days, but personal use crosses the 14-day-or-10% line. The IRS treats the ADU as your residence. You split every shared expense between rental and personal use by days, and your total rental deductions can’t exceed your gross rental income.² No loss. Unused deductions carry forward, but you lose the immediate tax benefit.

Fewer than 15 rental days all year. Section 280A(g) excludes the rental income from your gross income entirely. You don’t report it. You also can’t deduct any rental expenses. Useful for the occasional short-term rental, irrelevant if the ADU is a steady income source.

Pure personal use. Housing a family member rent-free generates no rental deductions. You keep mortgage interest and property taxes on Schedule A if you itemize. Depreciation, utilities, insurance, and maintenance are all off the table.

Operating Expenses You Can Deduct

Once the ADU qualifies as a rental, any ordinary and necessary expense of operating it is deductible against the rental income. The unit has to be placed in service — ready and available to rent — but it doesn’t have to be occupied every day. Vacancy between tenants doesn’t disqualify ongoing costs.

Utilities you provide: electricity, water, gas, trash, internet.
Insurance premiums on the structure, landlord liability coverage.
Property management fees.
Legal fees for lease drafting or eviction, and accounting fees for the rental activity. Fees to defend ownership of the property or to improve it are not current expenses.
Advertising and tenant screening, including background and credit checks.
Cleaning and turnover costs between tenants.
Mortgage interest on the ADU loan once the unit is in service.
Property taxes attributable to the ADU, including any increase from the municipal reassessment triggered by its construction.

Repairs Versus Improvements

A repair keeps the property in its existing condition: patching drywall, replacing a faucet, fixing a broken window. Deduct the full cost the year you pay it. An improvement adds value, extends useful life, or adapts the property to a new use: a new HVAC system, an added bathroom, new flooring throughout. Improvements get capitalized and depreciated. The IRS pays close attention to this line; miscategorizing an improvement as a repair is a common audit trigger.

If a repair or small purchase runs $2,500 or less per invoice or item, the de minimis safe harbor lets you deduct it immediately instead of capitalizing it.³ This covers things like a replacement water heater, a new appliance, or window blinds. You elect the safe harbor by attaching a statement to the return, and each item must be substantiated by an invoice.

Mixed-use owners have to split every shared operating expense based on the rental-use percentage, and the total rental deductions still can’t exceed gross rental income.

Depreciating the ADU

Depreciation is usually the biggest deduction an ADU generates, and it’s a non-cash deduction — you take it every year without writing a check. You can’t expense construction costs the year you pay them; they’re capitalized and recovered over the IRS’s assigned useful life.

Your Depreciable Basis

Basis is the total cost of the ADU structure minus the land value, since land doesn’t depreciate.⁴ Structural cost includes architect fees, permits, materials, labor, and impact fees. Interest paid on a construction loan during the build generally must be capitalized into basis rather than deducted as a current expense, under Section 263A(f).⁵ After the ADU is placed in service, ongoing loan interest becomes a deductible rental expense.

Splitting land from structure usually calls for a professional appraisal or a calculation based on your county assessor’s land-to-improvement ratio. Overallocating to land permanently reduces every year’s depreciation deduction, so getting the split right at the start matters.

27.5 Years, Straight Line

Residential rental property depreciates over 27.5 years, straight-line, under MACRS.⁶ Same dollar amount every year. A $275,000 basis produces a $10,000 annual deduction. First and last years use a mid-month convention: the IRS treats the property as placed in service at the midpoint of whatever month it became available for rent.⁴ Finish in March and your first-year deduction covers 9.5 months.

Capital improvements made after the unit is in service start their own 27.5-year schedule from their own placed-in-service date. Each improvement is tracked separately.

Claim It or Lose It Anyway

One rule catches many owners off guard. The IRS reduces your basis by the depreciation you were allowed to claim, whether or not you actually claimed it. Skip depreciation for a few years and the IRS still calculates your gain at sale as if you’d been taking it. You don’t avoid recapture; you just give up the annual deduction for nothing.

First-Year Bonus Depreciation on Components

The ADU structure sits on a 27.5-year schedule, but certain components of the project can be expensed in year one. Under the One, Big, Beautiful Bill signed in 2025, 100% bonus depreciation was permanently restored for qualified property acquired after January 19, 2025, including tangible property with a class life of 20 years or less.⁷

For an ADU project, the components most likely to qualify are:

Land improvements on a 15-year schedule: fences, driveways, sidewalks, patios, landscaping.
Personal property on a 5- to 7-year schedule: appliances, carpet, window treatments, and fixtures that aren’t structural components.

The building itself, as 27.5-year property, doesn’t qualify. To separate eligible components from the structure, many owners commission a cost segregation study, an engineering analysis that reclassifies parts of the construction into shorter-lived categories. The study itself is deductible. For a $200,000 ADU, a study might identify $30,000 to $50,000 in components eligible for first-year expensing.

The Passive Loss Problem and the $25,000 Allowance

Rental income is almost always passive income under Section 469. That matters because losses from passive activities generally can’t offset your wages or other active income — they can only offset other passive income. First-year ADU losses after depreciation often look large on paper and then don’t deliver the tax savings owners expect.

The small-landlord exception is the fix for most ADU owners. If you actively participate in managing the rental, you can deduct up to $25,000 of passive rental losses against non-passive income each year.⁸ Active participation is a low bar: approving tenants, setting lease terms, authorizing repairs. You also need to own at least 10% of the rental by value.

The $25,000 allowance phases out as modified adjusted gross income rises above $100,000. For every $2 of MAGI above that, the allowance drops by $1, hitting zero at $150,000.⁹ A single filer at $120,000 MAGI gets $15,000. Married filing separately while living with your spouse at any point in the year? Allowance halves to $12,500 with a lower phase-out range.

Losses above the allowance aren’t gone. They carry forward indefinitely and release in future years against passive income, or fully when you sell your entire interest in the property to an unrelated buyer in a taxable transaction.⁹

The 20% Qualified Business Income Deduction

Section 199A lets eligible taxpayers deduct up to 20% of net rental income from the ADU on top of everything above.¹⁰ On $15,000 of net rental income, that’s an extra $3,000 deducted. The hurdle is that rental real estate doesn’t automatically count as a trade or business under 199A.

Revenue Procedure 2019-38 provides a safe harbor. To qualify, you need all of the following:

250 hours of rental services per year, counting tenant management, maintenance, repairs, rent collection, and advertising. For enterprises four or more years old, 250 hours in at least three of the last five years.¹¹
Separate books and records for the ADU rental.
Contemporaneous logs showing hours, services performed, dates, and who did the work.
A statement attached to the return for each year you rely on the safe harbor.

Hitting 250 hours on a single ADU is realistic but requires documented effort year-round. Fall short and the rental might still qualify as a Section 162 trade or business on facts and circumstances, which is a harder argument. The QBI deduction was originally set to expire after 2025; the One, Big, Beautiful Bill extended it. Income-based limitations apply at higher earnings.

The 3.8% Net Investment Income Tax

ADU rental income is subject to the 3.8% net investment income tax if your MAGI exceeds $200,000 (single) or $250,000 (married filing jointly).¹² The tax applies to the lesser of your net investment income or the amount by which MAGI exceeds the threshold. Easy to overlook, meaningful at higher incomes.

What Happens When You Sell

Section 121 lets you exclude up to $250,000 of gain ($500,000 for married couples filing jointly) from the sale of a principal residence, provided you owned and lived in the home for at least two of the five years before the sale.¹³ An ADU rental complicates the exclusion two ways.

Depreciation Recapture

You can’t exclude gain equal to the depreciation you claimed (or were entitled to claim) after May 6, 1997.¹⁴ That portion is taxed at a maximum 25% rate as unrecaptured Section 1250 gain.¹⁵ Claim $50,000 of depreciation over the years and $50,000 gets recaptured at sale, Section 121 or not.

Attached Versus Detached

The physical layout matters. If the ADU is a converted room, basement apartment, or attached unit the IRS considers part of your home, you don’t allocate gain between rental and personal portions, and you don’t report the rental share on Form 4797.¹⁴ Depreciation still recaptures, but the rest of your gain goes through the full Section 121 exclusion.

If the ADU is a detached structure, the IRS may treat it as a separate property. You allocate sale proceeds and basis between the main home and the ADU, report the ADU portion on Form 4797, and apply Section 121 only to the residence portion. Gain attributable to periods of nonqualified use — when the ADU was rented and not used as your home — may not be excludable at all.

Forms and Records

Rental income and expenses go on Schedule E (Form 1040), Supplemental Income and Loss.¹⁶ Depreciation is calculated on Form 4562 and carried to Schedule E.⁴ If you’re claiming the $25,000 passive loss allowance or carrying losses forward, file Form 8582. Mixed-use owners should attach a statement showing the rental/personal allocation. Detached ADU sales involve Form 4797.

Keep records supporting every item of income and expense for at least three years after you file.¹⁷ For an ADU, that’s leases, deposit records, contractor invoices, utility bills, insurance policies, and whatever appraisal or calculation set your depreciable basis. Keep depreciation records as long as you own the property plus three years after the sale, because the basis calculation at sale depends on the entire depreciation history. If you’re relying on the QBI safe harbor, keep the contemporaneous time logs too.

1
Office of the Law Revision Counsel. 26 USC 280A – Disallowance of Certain Expenses in Connection With Business Use of Home, Rental of Vacation Homes, Etc.
2
Internal Revenue Service. Topic No. 415, Renting Residential and Vacation Property
3
Internal Revenue Service. Tangible Property Final Regulations
4
Internal Revenue Service. Publication 527, Residential Rental Property
5
Internal Revenue Service. Interest Capitalization for Self-Constructed Assets
6
Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System
7
Internal Revenue Service. Treasury, IRS Issue Guidance on the Additional First Year Depreciation Deduction Amended as Part of the One, Big, Beautiful Bill
8
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
9
Internal Revenue Service. Instructions for Form 8582 (2025)
10
Internal Revenue Service. Qualified Business Income Deduction
11
Internal Revenue Service. IRS Finalizes Safe Harbor to Allow Rental Real Estate to Qualify as a Business for Qualified Business Income Deduction
12
Internal Revenue Service. Net Investment Income Tax
13
Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence
14
Internal Revenue Service. Sales, Trades, Exchanges 3
15
Office of the Law Revision Counsel. 26 USC 1 – Tax Imposed
16
Internal Revenue Service. About Schedule E (Form 1040)
17
Internal Revenue Service. How Long Should I Keep Records