ADU rental on primary residence — depreciation question

[Budhadipta Dan]

I m debating whether it would make sense to build an ADU on the backyard of our current SFH property in South Bay Area (San Jose). Had a few questions:

- I understand that mortgage interest, prop taxes, insurance, and other expenses should be deducted from gross rental income for tax purposes. But given that this will be a rental unit, should the cost of building the ADU also depreciated (over 27.5 years)?

- if yes, what happens when I sell the entire house few years later? What is my cost basis? Is it = Original purchase price + cost of ADU development - depreciation as rental?

- what are typical financing strategies for building ADU? I have read Heloc is an option. But doesn't heloc's have much higher rates than typical mortgages? Are there cheaper financing options?

Thanks in advance.

[Natalie Kolodij]

It will be depreciated over 27.5 years. 

Since it's outside of your main residence it won't qualify if you sell as part of the primary residence exclusion. So the portion of gain related to that ADU would be taxable - or you can utilize a 1031 for that portion of the gain to have it be tax deferred as well.