ADU Tax Deductions: Depreciation, Passive Losses & QBI

The tax deductions you can claim on an accessory dwelling unit depend almost entirely on how you use it. Rent the ADU to a tenant at a fair market rate and keep your own use of the unit minimal, and you unlock operating expense write-offs, depreciation worth tens of thousands of dollars over time, and potentially a 20% deduction on the net rental income. Let a family member live there rent-free, and you get almost nothing beyond the mortgage interest and property taxes you already claim on Schedule A. Everything below assumes you’re in the first camp.

Your Use of the ADU Decides Everything

Section 280A of the Internal Revenue Code sorts an ADU into one of a few categories based on two numbers: days rented at a fair market rate, and days used personally.¹

The category that opens up the full deduction list is pure rental use: you rent the ADU for 15 or more days during the year 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 spend up to 20 days in it yourself without losing this classification. This is the setting the rest of this article assumes.

Mixed use kicks in when you rent for 15+ days but exceed the 14-day/10% personal use threshold. The IRS then treats the ADU as your residence.² You must split every shared expense between rental and personal use, and total rental deductions cannot exceed gross rental income. You can’t generate a loss to offset wages. Unused deductions carry forward.

Pure personal use, including housing a family member rent-free, generates no rental deductions at all. Depreciation is off the table. Utilities, insurance, and maintenance are not deductible. Only mortgage interest and property tax flow through to Schedule A, and only if you itemize.

One narrow provision worth flagging as a boundary: if you rent the ADU for fewer than 15 days all year, the rental income is excluded from gross income under Section 280A(g), but no expenses tied to that rental are deductible either. If you’re renting as a steady income source, this rule doesn’t apply to you.

Operating Expenses You Can Deduct

Once the ADU is placed in service, meaning ready and available to rent, the IRS lets you deduct any expense that is ordinary and necessary to operate it. These deductions offset rental income on Schedule E. The unit qualifies even during vacancy between tenants, as long as it’s genuinely available for rent.

Deductible operating expenses commonly include:

Utilities you provide: electricity, water, gas, trash, internet.
Insurance premiums on the structure, landlord liability policies, and related coverage.
Property management fees.
Legal fees for lease drafting or evictions, and accounting fees for the rental. Fees to defend title or to improve the property are not operating expenses.
Advertising and tenant screening, including background and credit checks.
Cleaning and turnover costs between tenants.
The mortgage interest on financing the ADU (once it’s in service), and the property tax attributable to the unit.

Property taxes deserve a specific note. Adding an ADU typically triggers a local reassessment based on the added value of the new structure, not the entire property. The resulting property tax increase is itself a deductible rental expense on Schedule E.

Repairs Versus Improvements

This distinction is one of the most common audit triggers, and getting it wrong changes your deduction from immediate to spread over decades. 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 full HVAC replacement, adding a bathroom, new flooring throughout. Improvements are capitalized and depreciated.

When a repair or small purchase costs $2,500 or less per invoice or item, you can elect the de minimis safe harbor and deduct it immediately rather than capitalizing.³ Appliances, a water heater, window blinds, and similar items usually qualify. The election is made by attaching a statement to your return each year, and every item needs an invoice.

Depreciating the Structure Itself

Depreciation is typically the largest single deduction an ADU rental generates, and it costs nothing beyond the construction dollars you’ve already spent. You can’t deduct construction costs as an operating expense the year you build. You capitalize them and recover them through annual depreciation.

Setting Your Depreciable Basis

Your depreciable basis is the total cost of the ADU structure minus the value of the land underneath. Land never depreciates.⁴ Structural cost includes architect fees, permits, materials, labor, and impact fees. Interest paid on a construction loan during the build period generally must be capitalized into basis rather than deducted currently, under Section 263A(f).⁵ Once the ADU is in service, ongoing loan interest becomes a deductible rental expense.

Splitting land value from structure usually calls for a professional appraisal or a calculation based on your county assessor’s land-to-improvement ratio. Inflate the land side and you permanently reduce every future year’s depreciation deduction.

27.5 Years, Straight Line

Residential rental property is depreciated over 27.5 years on the straight-line method under MACRS.⁶ Same dollar amount each year: a $275,000 basis produces a $10,000 annual deduction. The first and last years use a mid-month convention, treating the property as placed in service at the midpoint of the month it became available.⁴ Finish in March and your first year covers 9.5 months.

Capital improvements added later, a new roof or a deck, start their own 27.5-year clocks from their own in-service dates. Each is tracked separately.

Claim It or Lose It, Either Way

The IRS reduces your property’s basis by the depreciation you were allowed to claim, whether you actually claimed it or not. Skip depreciation for years, then sell, and the IRS still calculates your gain as though you’d been deducting all along. Skipping doesn’t save you from recapture. It just means you gave up the annual deduction for nothing.

Bonus Depreciation and Cost Segregation

The 27.5-year structure doesn’t qualify for bonus depreciation. But an ADU project bundles in other assets that do. 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

Components typically eligible on an ADU project:

Land improvements classified as 15-year property, including fences, driveways, sidewalks, patios, and landscaping installed as part of the ADU project.
Personal property with 5- to 7-year class lives, including appliances, carpet, window treatments, and non-structural fixtures.

Separating these from the structure usually calls for a cost segregation study, a detailed engineering analysis that reclassifies elements of the construction into shorter-lived asset categories. The study itself is deductible. On a $200,000 ADU, a cost segregation study might identify $30,000 to $50,000 in components eligible for first-year expensing.

Passive Losses and the $25,000 Allowance

Rental income from an ADU is almost always passive under Section 469, so losses generally cannot offset your wages or other active income. This is where new ADU owners get surprised: after depreciation, the ADU may show a tax loss, and that loss is trapped.

There is a valuable exception. If you actively participate in managing the rental, you can deduct up to $25,000 in passive rental losses against non-passive income each year.⁸ Active participation is a low bar: deciding on tenants, approving lease terms, or authorizing repairs is enough. 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 over $100,000, the allowance drops by $1, and it disappears completely at $150,000.⁹ A single filer at $120,000 of MAGI has $15,000 of allowance left. Married-filing-separately taxpayers who lived with a spouse during the year get a $12,500 cap and a lower phase-out range.

Losses beyond the allowance aren’t gone. They carry forward indefinitely, offsetting passive income in later years or releasing in full when you sell your entire interest in the property to an unrelated buyer in a taxable transaction.

The 20% Qualified Business Income Deduction

Section 199A can layer a 20% deduction on top of everything else, taken against net rental income from the ADU.¹⁰ On $15,000 of net rental income, that’s another $3,000 off. Rental real estate doesn’t automatically count as a trade or business for this purpose, though, so you need to qualify.

Revenue Procedure 2019-38 gives a safe harbor. You need all of the following:

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

Hitting 250 hours on a single ADU is realistic but requires documented effort spread across the year. Fall short and you can still try to qualify as a Section 162 trade or business on facts and circumstances, though that’s a harder argument. The QBI deduction was set to expire after 2025 but was extended by the One, Big, Beautiful Bill. It is also subject to income-based limitations at higher earnings.

One Tax the Deductions Don’t Erase

ADU rental income is subject to the 3.8% net investment income tax if your MAGI exceeds $200,000 for single filers or $250,000 for joint filers.¹² The tax hits the lesser of your net investment income or the amount your MAGI exceeds the threshold. Rental income after deductions counts as net investment income. Easy to overlook, meaningful for higher-income owners.

What Your Deductions Cost You at Sale

Every dollar of depreciation you claim (or were entitled to claim) reduces your basis and gets recaptured when you sell. Under Section 121, homeowners can exclude up to $250,000 of gain, or $500,000 for joint filers, on the sale of a principal residence, provided they’ve owned and lived in the home two of the preceding five years.¹³ The rented ADU changes that calculation in two ways.

First, depreciation claimed after May 6, 1997, cannot be excluded.¹⁴ That portion of the gain is taxed as unrecaptured Section 1250 gain at a maximum rate of 25%.¹⁵ Claim $50,000 of depreciation over the years, and $50,000 is recaptured at sale.

Second, the physical arrangement matters. If the ADU is a converted room, basement unit, or attached apartment that the IRS treats as part of your home, you don’t need to allocate gain between rental and residence portions, and the rest of your gain rides the Section 121 exclusion. If the ADU is a detached structure, the IRS may treat it as separate property, which forces an allocation of proceeds and basis and applies Section 121 only to your actual residence’s share. Whether the ADU is attached or detached becomes a tax question, not just a design one.

Where the Numbers Land on Your Return

ADU rental income and expenses go on Schedule E (Form 1040).¹⁶ Gross rent on line 3. Operating expenses across lines 5 through 19. Depreciation on line 18, backed by Form 4562.⁴ Claiming the $25,000 passive loss allowance or carrying forward unused passive losses means also filing Form 8582.

Keep the records that support every line. The IRS wants at least three years after filing for income and expense documentation.¹⁷ Leases, bank deposits, contractor invoices, utility bills, insurance policies, the appraisal or calculation behind your depreciable basis. If you’re using the QBI safe harbor, keep the contemporaneous time logs. Depreciation records need to survive for as long as you own the property plus three years after selling, because the basis math at sale draws on the whole history.

State returns generally require parallel reporting, though thresholds and methods vary. Confirm the mechanics with your state before filing.

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