How ADUs Affect Your Taxes: A Comprehensive Guide for Colorado Homeowners

Property Taxes and ADUs: What to Expect

One of the most immediate tax implications of adding an ADU is its impact on your property taxes. Here’s how it typically works:

Assessment Increases

When you add an ADU to your property, its assessed value will likely increase. Property taxes in Colorado are calculated based on the assessed value, which is determined by your local county assessor. Key points include:

• ADU Value Additions: The additional square footage, amenities, and quality of construction of your ADU will factor into the new valuation.
• Tax Rate Variations: Colorado’s property tax rates vary by county. For example, the effective tax rate in Denver County is around 0.6%, while Douglas County’s rate is closer to 0.5%.
• Reassessment Timing: Counties in Colorado reassess property values every two years. If your ADU is completed mid-cycle, the new value may not be reflected until the next reassessment period.

Taxable Value Adjustment

• Market Value vs. Assessed Value: The assessed value is a percentage of your home’s market value. In Colorado, residential properties are assessed at 6.765% of their market value (as of 2023).
• Example: If your home’s market value increases by $100,000 due to an ADU, your assessed value would rise by approximately $6,765, which would be subject to your local tax rate.

‍

Senior Property Tax Exemptions

If you currently benefit from Colorado’s senior property tax exemption, adding an ADU could alter your eligibility. Consult with your county assessor to understand the potential impact.

Added Value vs. Property Tax Increase

While it’s true that adding an ADU increases your property taxes, the financial benefits often far outweigh the costs. Here’s why:

Boosting Property Value

ADUs add significant value to your property, often increasing its market value by an average of 35%. In Colorado’s competitive housing market, properties with ADUs are highly desirable for their versatility and income potential. Buyers are willing to pay a premium for homes with rental-ready units or flexible living spaces.

Rental Income Potential

The rental income from an ADU can quickly offset any additional property taxes. For example:

• A well-designed ADU in Denver can rent for $1,500 to $2,500 per month, depending on size and location.
• Over a year, this could amount to $18,000 to $30,000 in rental income, far exceeding the typical property tax increase.

Long-Term Investment

Adding an ADU is an investment in your property’s future. The additional value and income potential can provide significant returns when it’s time to sell, making the initial tax increase a small price to pay for long-term financial benefits.

Income Taxes and Rental Income

If you rent out your ADU, you’ll need to report the rental income on your federal and state tax returns. Here’s how it works:

‍

Reporting Rental Income

Rental income from your ADU is considered taxable income. You’ll report it on Schedule E (Supplemental Income and Loss) of your federal tax return. Key details include:

• What Counts as Income: Rent payments, security deposits (if not refunded), and any additional fees charged to tenants.
• Short-Term vs. Long-Term Rentals: If you rent your ADU on platforms like Airbnb for fewer than 14 days a year, the income may not be taxable under the "14-Day Rule."

Deductions for Landlords

Operating an ADU as a rental property comes with potential tax deductions that can offset your rental income. Common deductions include:

• Depreciation: The cost of your ADU can be depreciated over 27.5 years for tax purposes.
• Operating Expenses: Utilities, property management fees, and maintenance costs are deductible.
• Mortgage Interest and Property Taxes: A portion of these expenses related to your ADU can also be deducted.

Self-Employment Taxes

If you provide significant services to your ADU tenants (e.g., cleaning, breakfast, or concierge services), the IRS may classify your activity as a business rather than a rental, subjecting the income to self-employment taxes.

Tax Benefits and Write-Off Opportunities for ADU Owners

Building an ADU doesn’t just add value to your property—it can also provide valuable tax benefits when utilized strategically. Homeowners in Colorado can take advantage of various deductions, credits, and write-offs to offset expenses and improve their financial outlook. Here’s how you can make your ADU work for you during tax season:

Rental Income Deductions

If you’re renting out your ADU, the IRS allows you to deduct a variety of expenses related to its operation, including:

• Maintenance and Repairs: Costs for fixing plumbing, replacing appliances, or repainting the ADU.
• Property Management Fees: If you hire a company to manage tenant relations or maintain the property.
• Insurance Premiums: The portion of your homeowner’s insurance allocated to the ADU.
• Depreciation: Spread the cost of constructing the ADU over 27.5 years, lowering your taxable rental income annually.

Dual-Use Tax Advantages

For homeowners using their ADU as both a rental property and personal space, specific tax benefits may still apply:

• Home Office Deduction: If you run a business from your ADU, you can claim a deduction for the portion of the space exclusively used for work.
• Shared Utilities: Allocate a portion of shared utility costs (e.g., electricity, water, internet) as a business expense if tenants or business use part of the ADU.

Green Energy Tax Credits

Colorado homeowners adding energy-efficient features to their ADU can benefit from federal and state incentives:

• Solar Investment Tax Credit (ITC): Deduct 30% of the cost of solar panel installation from your federal taxes.
• Energy-Efficient Upgrades: Receive credits for installing Energy Star-rated windows, HVAC systems, or appliances.

Tax Write-Offs for Short-Term Rentals

If you list your ADU on platforms like Airbnb or VRBO, you may qualify for additional deductions:

• Cleaning Fees and Supplies: Deduct costs associated with keeping your rental guest-ready.
• Marketing Expenses: Include fees for advertising or promoting your listing.
• Occupancy Taxes: Deduct local taxes collected and remitted for short-term rentals.

Planning for Future Tax Scenarios

ADU ownership isn’t just about the present—it’s also about long-term financial planning:

• Retirement Income: As you approach retirement, converting your ADU to a full-time rental can provide a steady income stream while you benefit from ongoing deductions.
• Legacy Property Strategy: If you plan to pass your property to heirs, including an ADU in your estate may increase its value while also offering rental income potential for the next generation.
• Property Tax Deferrals: Colorado offers property tax deferral programs for seniors and military personnel. Adding an ADU may still allow you to qualify if your primary residence remains within the program’s thresholds.

Challenges to Watch Out For

While ADUs offer many benefits, they can also introduce challenges related to taxes:

Increased Tax Liability

A higher property valuation means higher annual property taxes. Ensure you budget for this increase.

Complex Record-Keeping

If you’re renting your ADU, maintaining meticulous records of income and expenses is essential for accurate tax reporting.

Dual-Use Complications

Using your ADU for both personal and rental purposes can complicate deductions and exemptions. Consult with a tax professional to navigate these scenarios.

Potential Tax Audits

Rental income and deductions could potentially trigger IRS audits. Working with a tax advisor ensures your filings are accurate and compliant.

Case Studies: Real-Life Tax Implications of ADUs

Boulder Homeowner Renting an ADU

A homeowner in Boulder added an 800-square-foot detached ADU, renting it for $2,000/month. Here’s how it affected their taxes:

• Property Taxes: Increased by $1,200/year due to the higher assessed value.
• Rental Income: Generated $24,000/year in taxable income.
• Deductions: Claimed $8,000 in expenses, including depreciation, reducing their taxable income to $16,000.

Aurora Multigenerational ADU

A Family in Aurora built a 644-square-foot attached ADU for aging parents:

• Property Taxes: Increased by $1,500/year.
• No Rental Income: Since the unit wasn’t rented, there were no income tax implications.
• Capital Gains Planning: The ADU’s cost was added to the home’s tax basis, minimizing future capital gains taxes.

Longmont Investor ADU

An investor in Longmont built a 535-square-foot detached ADU specifically for long-term rental income:

• Property Taxes: Increased by $2,000 annually.
• Rental Income: The unit brought in $30,000 annually, allowing significant reinvestment.
• Tax Credits: Claimed $4,000 in energy efficiency credits due to solar panel installation.

Make Your ADU Work for You

Understanding how ADUs affect your taxes is a critical part of the planning process. By knowing what to expect and working with professionals, you can maximize your investment while minimizing tax liabilities.

At Kindred Tiny Homes, we don’t just build ADUs—we guide you through every step of the journey, including understanding the financial and tax implications. Whether you’re planning to rent, use the space for family, or enhance your property’s

‍