The incremental cash-on-cash framework
An ADU (accessory dwelling unit) is typically a garage conversion, basement apartment, detached backyard unit, or attached addition. The return analysis treats the ADU as an incremental investment:
Cash invested = construction cost (all in: design, permits, construction, landscaping, appliances). Typical range: $80,000–$250,000+ depending on type and location.
Annual cash flow = gross rent − vacancy − operating expenses (insurance, utilities, maintenance allocation, property management if applicable). Do not include mortgage on the main property — the ADU sits on existing debt.
Incremental cash-on-cash return = annual cash flow ÷ construction cost. A $120,000 garage conversion generating $1,500/month net ($18,000/year) produces a 15% cash-on-cash return — higher than buying a separate property at current prices in many markets.
Depreciation on an ADU
If the ADU is part of your primary residence (e.g., a basement unit), you must allocate the basis between residential personal use and rental use. Only the rental portion is depreciable.
For a detached ADU constructed on a rental property: the full construction cost (less any land portion) is depreciable as a separate structure. The recovery period is 27.5 years (residential rental).
For a detached ADU at your primary home: the portion used for rental is a separate rental property for tax purposes, depreciating over 27.5 years. When you sell the main house, the Section 121 exclusion applies only to the personal-use portion; the rental ADU portion may generate depreciation recapture.
Practical considerations before you build
Local permitting and zoning: many jurisdictions have ADU-friendly laws that streamlined permitting, but confirm your municipality allows the type of ADU you want. Permits affect the placed-in-service date (when depreciation starts).
Financing: construction costs may be funded by a HELOC, cash-out refinance, or construction loan. The interest on a loan used to build a rental ADU is deductible as a rental expense (mortgage interest tracing rules apply).
Upside and risk: an ADU typically adds value to the property (increasing appreciation), but construction overruns are common. Budget a 15–20% contingency. The return analysis should use conservative rent estimates and include a vacancy assumption even in tight markets.
Frequently asked questions
Is an ADU eligible for depreciation?
Yes. The construction cost of an ADU used for rental is depreciable over 27.5 years as residential rental property. If part of your primary home, only the rental portion is depreciable.
What is a good cash-on-cash return on an ADU?
ADUs in high-cost markets often pencil at 8–15% because construction is cheaper relative to local rent levels. Below 6% starts to look weak relative to alternatives.
Does adding an ADU affect my Section 121 exclusion?
It can. The rental-use portion of your home — including a rented ADU — may generate depreciation recapture not sheltered by the Section 121 exclusion when you sell.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.