Financial Planning for an Accessory Dwelling Unit: What Real Estate Investors Need to Know

By Cynthia Meyer, CFA®, CFP®, ChFC®

What you will get from this article:

Did you know that your backyard could be a stream of income? With an accessory dwelling unit (ADU), you can generate rental income from a home that you already own. 

In this blog, I am going to talk about what an accessory dwelling unit is, some common types of ADUs, and how they are treated (and even encouraged) in different parts of the country. I’ll also break down some considerations for tax and financial planning for an accessory dwelling unit, based on things I’ve seen come up as a financial planner for real estate investors.

What is an Accessory Dwelling Unit?

An accessory dwelling unit is any secondary housing unit on a single-family residential lot. 

While ADUs have always been around, the name “accessory dwelling unit” has a more modern context. Previously, you may have heard these units referred to as a granny flat, granny unit, in-law suite, backyard cottage, casita, garage apartment, etc. Whatever the name, think of an ADU as creating a rental unit on the property of a single-family home.

Why would a homeowner create an accessory dwelling unit?

Approximately 40% of those creating an ADU are looking to rent the property out to bring in additional income in their property. While that intent depends on the state the property is located in, an ADU can bring in extra rental income to subsidize the homeowner’s lifestyle or the high cost of housing. 

Many states have been creating legislation around ADUs, particularly those where low-to-moderate income housing is tight and hard to build. States like California, Massachusetts, Oregon, Washington, and Vermont, for example, have passed legislation encouraging the building of ADUs. 

These units create a win-win scenario for homeowners, renters, and local jurisdictions that can benefit from housing being built quickly without the permitting issues that come with building multifamily housing.

What Types of Accessory Dwelling Units Are There?

Depending on the city and state you live in, the different types of units allowed may vary (so, of course, real estate investors will want to check local regulations before building one), but there are two general categories of ADUs that we will break down:

• Detached Accessory Dwelling Units: These units are small-to-medium-sized houses in your back or side yard. These standalone units are usually at a maximum of approximately 1200-1500 square feet in size.
• Attached Accessory Dwelling Units: These ADUs are created as extensions of the property’s main house, like building additions with rental units, or converting an existing component of the house into an ADU. Think of an English basement or garden apartment with a separate entrance, kitchen, and bathroom.

Depending on the city, homeowners and real estate investors may be able to have a detached ADU in the yard and an attached ADU or junior accessory dwelling unit (JADU) added to the property’s existing structure.

Some cities, like Seattle, for example, will even allow homeowners to pass more quickly through the permit process by creating an accessory dwelling unit from an existing prototype plan. This allows real estate investors to get the unit up and running quickly.

How to Finance an ADU

As a financial planner for real estate investors, we see clients finance accessory dwelling units in a few different ways.

HOme Equity Line of Credit (heloc)

A common way of financing an ADU is by using a home equity line of credit (HELOC). This allows homeowners to tap into the equity they have in the property beyond what’s owed in their primary mortgage to borrow against and finance the costs of building their ADU.

Many homeowners use a HELOC to finance building their ADU for the benefits that come with the line of credit. One benefit is that they may be able to deduct some of the interest on building the unit against the potential ADU rental income, as HELOCs are interest-only for the initial draw period. This allows homeowners to make principal payments that can immediately lower the cost of the loan for the next month.

Accessory dwelling units can cost anywhere from $50,000 to $350,000 or more, depending on the state and unit built, so having a HELOC or a combination of a HELOC and cash savings can help homeowners finance the project. 

If you’re considering using a HELOC to finance the building of an accessory dwelling unit, it’s worth consulting your financial planner to see whether a HELOC makes sense for you and your situation.

Cash out refinance

Another ADU financing option for homeowners or real estate investors is using a cash-out refinance. Although these aren’t as common when interest rates are high, cash-out financing allows you to refinance your home mortgage and take some extra cash out to build the ADU. 

Cash-out refinance loans make the most sense when:

• The homeowner does not currently carry a mortgage on their home OR
• The homeowner wants predictable monthly payments that include both interest and principal.
• AND Mortgage rates are lower than or similar to the homeowner’s current mortgage rates

grants or special loan programs

Some jurisdictions also offer grants or special loan programs for building an ADU, so it may be worth investigating the programs available in your local area. For example, Boston’s new ADU Home Loan Program offers eligible homeowners a 0% deferred loan of up to $50,000 to create an ADU on their 1-3 unit property. See MA ADU expert Tyler Munroe’s overview of the new state law and benefits for MA residents.   

New York City has recently implemented a pilot for accessory dwelling units called the Plus One Ancillary Dwelling Unit Program. The city is moving slowly towards a comprehensive ADU program as part of the City of Yes for Housing Opportunity zoning amendments.  NYC property owners who want to participate in future ADU programs as they become available can use this Plus One ADU Interest Form.

California Housing Finance Authority also had a very popular ADU Grant program that coordinated with the construction loan lender, though fully allocated, could receive some more funding in the future, and is worth keeping an eye on.

construction-to-permanent loan

Another way of financing an accessory dwelling unit is with a construction-to-permanent loan. While this ADU financing option is interest-only in the initial construction period, this ADU financing option would require refinancing the primary mortgage at the end of the construction period. 

These types of ADU loans may be better suited for those with a paid-off mortgage who know for sure that they want to move to an amortized loan at the end of the period, and don’t want to do a HELOC.

Hard Money lenders

Hard money loans are private loans made to the homeowner by an investor. These ADU loans are typically at the highest mortgage rates with a balloon payment at the end of the period (usually somewhere between 12 to 18 months).

Hard money loans for ADUs may be appropriate if the project is short and can be paid off or refinanced in another way at the end of the loan period.

Considerations for Financing an ADU

Before building an accessory dwelling unit, there are a few things you want to consider:

run the numbers

When planning to finance an accessory dwelling unit, you want to have a spending plan for the project. For example, at Real Life Planning, when clients are considering building an ADU or adapting an existing structure to be an ADU, the first thing we’ll do is run a rental property analysis. 

This allows us to make sure there is going to be a return on the investment with all of the costs that go into the ADU, including financing costs, and what a reasonable rent will be with a reasonable vacancy rate and some reasonable expenses.

tax planning

Another thing to consider when it comes to ADUs is tax planning. With ADUs, you have the component of the house that is your primary residence, which is treated as one for tax purposes. Other than your property taxes, up to the SALT limit, your expenses are not deductible in your primary residence. Then, you have the other component(s) of the property that represent the rental unit and can be treated as a rental, reported on Schedule E.

For these properties, the expenses would be based on a proportionate share of the mortgage interest, the property taxes and insurance, the maintenance costs, any direct expenses to that property, and then a proportion of the depreciation as a percentage of the total square footage on the entire property.

So, if your house represents 75% of the square footage of your property, and the ADU represents 25%, you would generally take one-quarter of those expenses against the ADU rental income. This can be a big advantage for many homeowners.

landlord responsibilities

Another consideration for building an ADU is whether or not you want to be a landlord, which is something else that we talk about with clients considering these units. 

Not everybody is cut out, or interested in, being a landlord. If you are building a residence 15 feet behind you on your property, you have to consider how this will affect your home environment. You’ve likely been used to living in the house all by yourself or with your family, and now you have to adjust to having a tenant on your property. 

You also have to consider the added responsibilities and compliance with Fair Housing Laws, and decide if this is something you want to take on. You could certainly use a property manager to interface with your tenant as the owner of an accessory dwelling apartment, though this isn’t common.

other considerations

There are a few other considerations that you want to keep in mind when it comes to building and financing an accessory dwelling unit for your property.

Insurance: Having an accessory dwelling unit on your property would change your insurance policy from a homeowner’s policy to an owner-occupied dwelling policy, so it’s crucial to consider how this will affect your costs and if this is something you’re interested in doing before renting out an ADU.

Operations: Separate your rental finances from your personal finances. It may be a good idea to set up a separate account for the rental activity so that it’s easier to track what’s coming in and what’s being expensed.

STRs Not Permitted: It’s worth noting that accessory dwelling units are generally not eligible for short-term rentals in most places. The legislative goal for this is to make sure these units provide additional rental housing, instead of a vacation house for a short stay. Some homeowners opt to rent them out as mid-term rentals; however, these are generally meant to be for long-term rental housing.

Trends in Accessory Dwelling Units

One of the most interesting trends that I’ve seen as a financial planner for real estate investors is the trend of using manufactured housing as an ADU. In these cases, homeowners will put in a foundation, buy a manufactured home, and have a contractor come in to install it and hook up the plumbing, electricity, etc. 

This trend is particularly interesting because the cost of a manufactured home is relatively reasonable these days, so it allows homeowners or real estate investors to put a lid on their costs and generate additional income.

Before You Start Your ADU Project

If you’re considering building an ADU on your property, there are a few things to consider before you start the project. 

• Check all of the rules in your area and fully understand the process. Most of the areas of the country that are encouraging homeowners to build ADUs offer guides and other resources about the process to make it easier.
• Interview at least three contractors who are skilled and experienced in setting up ADUs to make sure you understand their experience, how they can fit into your cost parameters, and their understanding of the permitting process.
• Talk to a trusted financial planner, preferably a real-estate-savvy financial planner, to help you determine whether this makes sense for you and your unique situation. You’re going to be becoming a landlord, so you want to be really clear on the landlord-tenant rules where you live and make a decision about hiring a property manager or not.

At the end of the day, accessory dwelling units are an interesting trend in the real estate industry, and they provide homeowners with an opportunity to generate more income in a more dense urban area. 

If you are considering building an ADU and want to see if generating an income stream from your backyard is the right step for you, we’d love for you to schedule a call with our team, where we can look at your unique situation and make a more confident, informed decision.

If you’re looking for an experienced and dedicated real estate financial planner and want to see if Real Life Planning is the right fit for you, we’d love to have you book a discovery call with our team.

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