If you're planning to rent out your ADU, the tax side of the equation matters just as much as the construction cost. Here's a general overview of how it typically works, though this is genuinely an area where you want a CPA's eyes on your specific situation before making decisions.
Rent you collect from an ADU tenant is taxable income, reported similarly to any other residential rental property. The upside is that, as a rental, the ADU also becomes eligible for the deductions and depreciation available to rental property owners generally.
Residential rental property is generally depreciated over 27.5 years under the standard MACRS schedule. A detached ADU (a true backyard cottage or converted detached garage, physically separate from the main house) is typically treated as its own residential rental property and depreciated on that 27.5-year schedule.
Attached ADUs, like an internal conversion or an addition sharing a wall or roofline with the main house, can be more complicated. The IRS generally requires that at least 80% of a building's gross rental income come from dwelling units for it to qualify for the same residential rental treatment, which can affect how an attached unit is classified if you also live in the primary home.
Some ADU owners use a cost segregation study to reclassify certain components of construction cost (specific finishes, fixtures, or systems) into shorter depreciation categories, allowing a larger deduction sooner rather than spread evenly over 27.5 years. With 100% bonus depreciation restored under recent federal tax legislation, a meaningful share of a typical ADU's construction cost can potentially qualify for this kind of accelerated, first-year treatment. This is a specialized strategy that requires a professional cost segregation study to execute correctly, it's not a DIY spreadsheet exercise.
If your rental produces a paper loss (common in early years once depreciation is factored in), there are limits on how much of that loss you can deduct against your other income, particularly once your modified adjusted gross income rises above roughly $150,000. Below certain income thresholds, more of that loss may be usable; above them, it may be limited or carried forward instead.
Adding an ADU generally increases your property's assessed value, which can mean a higher property tax bill going forward. This is a real, recurring cost worth factoring into your rental income math from day one, not something to be surprised by after your first post-construction assessment notice arrives.
We can't advise you on your taxes, but we can give you accurate, specific construction cost documentation and a clear breakdown of attached vs. detached classification for your unit, which is exactly the information your CPA will need to do this analysis properly.