Investing in an accessory dwelling unit (ADU) can be a great way to generate passive income, increase property value, and make better use of available space. However, renting out an ADU comes with legal and tax responsibilities that homeowners need to understand before listing the unit. Failing to comply with local regulations or mismanaging tax obligations can lead to hefty fines and unexpected financial burdens.

Avoid legal headaches when Renting Out Your ADU!

This guide explores key legal and tax considerations to help homeowners rent out their ADUs while staying compliant and making informed financial decisions.

Legal Requirements for Renting Out an ADU

Before renting out an ADU, it is essential to check state, county, and city regulations to ensure compliance. Laws regarding ADUs vary widely depending on location, and what is allowed in one city may be restricted in another.

Local Zoning Laws and Short-Term Rental Restrictions

Many cities in California have embraced ADUs to address housing shortages, but specific zoning laws still dictate how they can be used. Some areas limit short-term rentals (such as Airbnb) to a minimum stay of 30 days, while others prohibit them entirely.

For homeowners considering short-term rental options, the following steps can help clarify local rules:

• Check city and county websites for ADU rental regulations
• Speak with the local planning department to confirm compliance requirements
• Review restrictions on rental duration, tenant screening, and occupancy limits

Ignoring zoning laws can result in penalties or even eviction notices for tenants, so it is crucial to verify all guidelines before proceeding.

Rental Agreements and Tenant Protections

California is known for its tenant-friendly laws, and renting out an ADU falls under the same legal framework as any other rental property. Homeowners should be familiar with:

• Lease agreements – A well-drafted lease should outline rental terms, security deposits, maintenance responsibilities, and eviction policies
• Rent control laws – Some cities have rent caps that limit annual increases
• Eviction regulations – Landlords must provide legal justification and proper notice before evicting tenants

Understanding these protections helps landlords avoid legal disputes and ensures tenants receive fair treatment under state law.

Permit Compliance and Homeowners Association (HOA) Rules

An ADU must be built with the proper permits before it can be legally rented out. If the unit was constructed without approval, homeowners may face fines or be required to bring the structure up to code.

Additionally, for properties within a homeowners association (HOA), additional rules may apply. Some HOAs restrict renting out secondary units, so it is advisable to review association bylaws before making any commitments.

Tax Considerations When Renting Out an ADU

Renting out an ADU affects tax obligations at both the state and federal levels. Understanding how rental income is taxed, which deductions apply, and potential property tax changes can help homeowners avoid surprises during tax season.

Rental Income and IRS Reporting

Any income earned from renting an ADU is taxable and must be reported to the IRS. Even if the rental is a casual arrangement or rented for only part of the year, homeowners are required to declare the earnings.

The IRS treats rental income differently depending on the usage of the unit:

• If rented out for fewer than 15 days per year, it may be exempt from taxation
• If used for both personal and rental purposes, expenses must be divided accordingly when filing taxes
• If rented out full-time, all rental income must be reported, and eligible expenses can be deducted

Tax Deductions for ADU Landlords

Landlords can reduce their taxable income by claiming deductions on certain expenses related to renting out an ADU. These may include:

• Mortgage interest related to ADU financing
• Property management fees
• Repairs and maintenance costs
• Utilities (if paid by the homeowner)
• Insurance premiums for rental property coverage

Keeping detailed records of these expenses ensures homeowners can claim appropriate deductions and reduce tax liabilities.

Property Tax Implications

Many homeowners worry about how adding an ADU might affect their property taxes. In California, Proposition 13 helps keep property taxes stable, but new assessments may apply when an ADU is built.

• Property tax increases depend on the construction cost of the ADU, not the value of the entire property
• Some counties offer exemptions or reduced tax assessments for ADUs used as affordable housing
• Homeowners should consult local tax assessors to understand potential changes in tax bills

Depreciation Benefits for Rental ADUs

Since ADUs are considered rental property, homeowners can claim depreciation as a tax benefit. Depreciation allows landlords to deduct a portion of the ADU’s value over several years, reducing taxable income.

For example, if an ADU costs $150,000 to build, depreciation may allow deductions of approximately $5,000 per year for 27.5 years under IRS guidelines. This can be a valuable tax advantage for long-term rental arrangements.

Insurance and Liability Considerations

Renting out an ADU changes the homeowner’s liability risk, making adequate insurance coverage essential. Standard homeowner’s insurance policies may not fully cover rental units, so obtaining a landlord insurance policy is advisable.

Key Considerations for ADU Rental Insurance

• Liability protection – Covers legal expenses if a tenant is injured on the property
• Property damage coverage – Protects against fire, vandalism, or weather-related damage
• Loss of rental income – Provides compensation if the unit becomes uninhabitable due to covered damages

Speaking with an insurance provider about these options ensures homeowners are adequately protected against potential risks.

Making the Right Financial Decisions

Beyond legal and tax considerations, homeowners must decide how to structure their rental arrangement to align with their financial goals.

Short-Term vs. Long-Term Rentals

Choosing between short-term and long-term rental models impacts income potential, tenant turnover, and regulatory requirements.

Short-Term Rentals (Airbnb, VRBO):

• Higher rental income potential
• More frequent tenant turnover
• Stricter city regulations in many areas

Long-Term Rentals (Month-to-Month or Annual Lease):

• Stable, predictable income
• Fewer management hassles
• Tenant protection laws apply

Evaluating local market demand and regulatory factors can help homeowners choose the right rental strategy.

Self-Managing vs. Hiring a Property Manager

Managing an ADU rental requires time and effort. While some homeowners prefer to handle tenant screening, maintenance, and rent collection themselves, others opt for a property management company to oversee these responsibilities.

Consider hiring a property manager if:

• You don’t have time to handle tenant inquiries and maintenance
• You own multiple rental units
• You live far from the ADU

While property management fees typically range from 8% to 12% of rental income, they can be a worthwhile investment for landlords who want a hands-off approach.

Final Thoughts

Renting out an ADU can provide a valuable source of income, but it comes with responsibilities that homeowners must take seriously. Understanding local rental laws, tax implications, and insurance requirements can help you avoid costly mistakes and ensure a smooth rental experience.

Before listing an ADU for rent, homeowners should:

• Verify local zoning laws and tenant regulations
• Secure the proper permits and insurance coverage
• Keep accurate financial records for tax purposes
• Decide between short-term and long-term rental strategies

For those considering building an ADU specifically for rental income, working with an experienced ADU builder can simplify the process. With the right preparation and knowledge, renting out an ADU can be both a profitable and stress-free experience.