Converting Basement, Garage Or ADU Into An STR

By Jason Watson, CPA
Posted Sunday, September 14, 2025

Many homeowners become real estate investors overnight when they take a basement or garage, convert it into a dwelling unit, and make it a short-term rental (or even a mid-term or long-term rental). Same thing with an auxiliary dwelling unit (ADU) which is also the same as casita, guest quarters, mother-in-law quarters, granny flat (our fav), or guest house.

Many call this house hacking, and it is a common strategy for homeowners to offset the costs of ownership.

What are some of the considerations when making your basement, attic, garage or ADU a short-term rental? And, can you leverage the short-term rental loophole with the house hacking arrangement? Can I use the Augusta rule that my bartender told me about? What about cost segregation study? Slow down love, let’s take some time and go through each of these. Geez, we just met.

Dwelling Unit Defined

IRS Publication 527 Residential Rental Property and proposed Treasury Regulations Section 1.280A-1(c)(2) provide a definition of a dwelling unit. This comes from the tax code, or IRC Section 280A(f)(1)(A), which reads-

IRS Publication 527 takes this one step further and adds some qualifiers-

A dwelling unit has basic living accommodations, such as sleeping space, a toilet, and cooking facilities.

Boaters would say berthing quarters, head and galley. Not sure what astronauts would say but we can agree that the space station would be a dwelling unit. Average guest stay seems to be on the higher side, however.

The definition above is the must have. If you wanted to throw a little icing on the cake, you would also have a separate entrance, address and utility meters but that might be asking a lot.

We define dwelling unit since some homeowners want to rent out a bedroom and claim the short-term rental loophole. Besides the 38 cents of accelerated depreciation not really blowing anyone’s hair back, IRS guidance doesn’t treat a bedroom alone as a separate dwelling unit. Yes, you can still rent your bedroom to others, it just doesn’t qualify for the STR loophole since it is not a separate dwelling unit.

Can we get a “yeah, but?”

What if your bedroom has a separate entrance and is en suite (fancy talk for bathroom)? Getting closer. What if you add a hot plate and mini fridge? You now have sleeping space, a toilet and cooking facilities in the eyes of IRS Publication 527 Residential Rental Property. Be careful, however- form over substance comes to mind so ensure your technical facts are supported with reasonable meaning and intent.

Short-Term Rental Aspect

While you can rent out your primary residence tax-free under the Augusta rule (officially IRC Section 280A(g)(1)), you can also leverage the short-term rental loophole with your converted basement, attic or garage, or ADU. Provided you can demonstrate that the space is a dwelling unit, and that you meet the average guest stay of 7 days or less, and that you materially participate as we’ve defined a zillion times in this chapter and others, you are good to go.

Anyone want the exact language that makes up the Augusta rule? Sure you do! Here is IRC Section 280A(g)(1)–

Neat.

Sidebar: The Augusta rule comes from tax folklore and the Masters Tournament in Augusta, Georgia. It lasts 7 days and is held during the first week of April. Clearly not well-attended by tax professionals.

What about cost segregation?

Cost Segregation Study For Your Converted Basement

As a refresher, a cost segregation study takes typical IRC Section 1250 real property that is depreciated over 27.5 or 39.0 years, and carves out certain property that is identified as IRC Section 1245 personal property. Next, the personal property is chopped up into 5-, 7- and 15-year depreciation buckets (assert classes for nerdy accountants).

Wait! There’s more. Personal property is eligible for accelerated depreciation either through bonus depreciation or Section 179 expensing. See our accelerated depreciation and Section 179 deduction section for more information.

Let’s take a step back. If you are considering a cost segregation study on a converted basement, attic or garage, where the rental space is part of the entire building, then you need to determine a business use percentage. Shared HVAC, plumbing, electrical and other building systems and components can add complexity to a cost segregation study.

Calculating the business use percentage or rental use is typically done with square footage. Keep in mind that when you convert a space that is normally not livable, and you make it into a dwelling unit complete with kitchen, bedroom (including studio) and bathroom, the new or additional square footage is added to both numerator and denominator.

Said differently, if your livable space is 2,500 square feet, and you convert your garage adding 400 square feet, the math becomes 400 divided by 2,900 for business use percentage.

But here is where it gets tricky. An attic or basement is attached to the house, however, a garage can be detached with its own four exterior walls and as such becomes an auxiliary dwelling unit (keep reading) for cost segregation purposes. Covered breezeways between the main home and detached garage, and essentially a connected roof, does not suddenly make it attached. Generally, a structure needs to have structural continuity with the primary building, such as shared foundation or walls, to be considered attached.

If you are working with a cost segregation engineer, you will need to explain the space. If you are doing a do-it-yourself cost seg study, which is completely fine and appropriate, you will generally need to apply the business use percentage as calculated above to the building to determine your starting point. Said differently, your basis will need to be allocated between personal and business (rental property).

WCG CPAs & Advisors recommends contacting the cost segregation people and getting additional guidance under a DIY cost seg. At the very least you will need to document the method for determining business use (rental portion) and support the conversion of the space with photos. If the space was converted with renovations, then permits, receipts, plans, etc. should be maintained as part of your record keeping as well.

Cost Segregation Study For your ADU

Cost seg for an auxiliary dwelling unit is straightforward since an ADU is viewed as a separate structure just like a single-family rental property. It gets a little complicated when you have a detached garage that was part of the original purchase price.

For example, you invest $150,000 into adding electricity, gas, water and sewer to the structure plus all the usual things like drywall, cabinets, floor coverings, etc., and what is your new cost basis in the garage turned ADU? An easy solution is to start with a business use percentage based on square footage as we explained earlier and then add the $150,000 to it.

Land would not be allocated to the rental activity since it cannot be divided. In other words, you cannot sell the ADU separately from the primary house (sure, you can do a survey and create some magic with the county, and be allowed to sell a land lease interest, but that seems a bit nutty).

Capital Gains Exclusion Under IRC Section 121

Keep in mind this rather thorny part of the tax code. IRS Publication 523 Selling Your Home reads in part-

Space separate from the living area.
You generally can’t exclude gain on the separate portion of your property used for business or to produce rental income. Regulations section 1.121-1(e) provides that the use of a separate portion of your home for business or rental purposes doesn’t qualify for exclusion under section 121, and this may affect your gain or loss calculations.

See our selling your rental property section for more riveting information on primary residence conversion including non-qualified use, separate spaces as we described here, net investment income tax (spoiler, make it an STR before you sell), purchase price allocation and land arbitrage, among other things. Fun!