Investors and ADU Occupancy Requirements

Owner occupancy requirements on accessory dwelling units have been relaxed due to state regulations. There is still some ambiguity around what constitutes an owner occupant, and specifically, if certain types of ownership structures would allow an investor to have both an ADU and a junior ADU (JADU). Read on for our take on these questions, and be sure to consult your own legal sources for confirmation.

What are the owner occupancy requirements for accessory dwelling units (ADUs)?

California law has eliminated all owner occupancy requirements for ADUs permitted between January 1, 2020, and January 1, 2030, and local agencies cannot retroactively require owner occupancy for those ADUs (Gov. Code, § 65852.2, subd. (a)(6)). Previously local agencies could decide whether the primary dwelling or the ADU would be required to have owner occupancy.

If a property has both an ADU and junior accessory dwelling unit (JADU), the law requires owner-occupancy of either the newly created JADU, or the single-family residence. So if you decided to move, you would technically have to stop renting out the JADU since the primary residence will not be owner-occupied.

This is also where we get into more complex questions regarding the definition of “owner occupied.”

If an investor-owner is a legal entity (LLC, S-Corp) does that preclude the investor from having a junior accessory dwelling unit (JADU)?

 

What defines Owner-Occupied?

The California laws related to ADUs do not provide a definition for the term “owner-occupied.” The term “owner-occupied” is a term that generally was created for the IRS and tax purposes, though cities also typically follow this term of art. Conversely, legally a business (LLC/S-Corp) is a non-living legal entity.

For further context, let’s look at the code for several municipalities where the term “owner-occupied” is addressed:

Carlsbad

The term “owner-occupied” only shows up one-time in the entire Carlsbad Municipal Code as it relates to converting a primary dwelling to a rental dwelling. But, “owner-occupant” itself isn’t defined.

Encinitas

Encinitas Municipal Code is both expanded and restrictive. The code states that prior to issuance of a building permit for a JADU, a covenant shall be recorded between the owner and the City of Encinitas stating that “the owner of a lot with a JADU shall occupy as a principal residence either the primary dwelling or the JADU, except where the primary dwelling and junior accessory dwelling are held by an agency such as a land trust or housing organization in an effort to create affordable housing.”  Nevertheless, in most cases, this exception wouldn’t be much assistance for an investor/owner.

City of San Diego

The City of San Diego Municipal Code comes close to defining what an owner is in a completely separate section of code by stating that an “OWNER means the person or persons owning and occupying real property in The City of San Diego.”

What are the definitions that pertain to LLCs and S-Corps?

In order for a property to be owner-occupied, a living person owner must move into the residence within 60 days of closing and live there for at least one year. For the homes where an ADU will be added, the owner must live at the residence for the majority of the year (typically defined as spending at least 70% of the time living at the homes).

A business (LLC/S-Corp) is a non-living legal entity. A business does not occupy anything. It only exists on a piece of paper. As such, a LLC or S-Corp will likely not qualify as an “owner-occupant” and a JADU most likely wouldn’t be allowed, even if the LLC or S-Corp is a single member company.

Nevertheless, the LLC or S-Corp can buy and hold real estate. And as far as the IRS is concerned, the single member LLC/S-Corp will be treated the same as a single person living in their home. So, a single person LLC/S-Corp wouldn’t receive the benefit of renting to themselves.

Does an owner-occupant have to be a real person to have a JADU?

“Owner-occupied” most likely will be required to be a “person,” which by legal definition is a living being. An LLC or S-Corp is not a living being. Thus, a LLC or S-Corp will likely not succeed in applying for a ADU + JADU. Nevertheless, because the term isn’t specifically defined in the municipal codes, it could be worth investigating if a city would deviate from this understanding of “owner-occupied” and apply it to single member LLCs and S-Corps where the sole member/shareholder is the primary resident of the primary dwelling unit.

Can an owner-investor draft a lease with a tenant stating that as a product of the lease, the tenant has some sort of participation in the legal entity (LLC, Corp, LP, etc.)?

This potential exchange would be two parties bargaining a) a leasehold interest for b) shares/interest in a Corp/LLC (LLCs have ‘interests’ and S-Corps have ‘shares,’ otherwise they are similar). This would fall under contract law, and there is no obvious reason why the parties couldn’t exchange the value of a lease for shares/interest.

The question for the parties would be, “How valuable is the leasehold interest?” And are the shares/interest in exchange for rent, or the actual leasehold itself?  Regardless, if the owner/investor valued shares/interest in the LLC/S-Corp at a rate equal to the leasehold, there is no reason why not.

Would it require a secondary step to actually amend the corporation documents to make the tenant a member?

In order to add a shareholder to the corporation, either an existing shareholder must transfer some of his/her shares in the corporation to the new shareholder, or the corporation itself must issue shares of stock to the new shareholder.

If the company issues the shares, there are two possibilities.

  1. Issue Stock Certificate:  If the corporation holds shares that have been previously issued (treasury stock) then it can simply issue those shares to the new shareholder. This wouldn’t require amending the articles of incorporation, charter, or bylaws. They would simply need to issue a new stock certificate to the 3rd party and record the transaction in the company’s stock ledger.
  2. Amend Corporate Charter: The S-Corp must check its articles of incorporation to determine the total number of authorized shares. The difference between authorized shares and the number of currently issued and outstanding shares represents the maximum number of new shares. If any available, issue stock certificate, pre above. However, if there are no remaining authorized shares, then the corporation must amend the articles of incorporation to increase the total amount of shares available (subject to Board approval), then issue those shares per above.

What are the financial implications of issuing shares/interest?

There are financial implications here as well:  If the 3rd party is issued shares/interest and they did not make any cash or property investment but receive shares in return, from the tax perspective, the fair market value (FMV) of the shares will need to be included as taxable compensation on this person’s tax return. A leasehold would likely not be a sufficient property interest, especially when the leasehold as described would be flowing the wrong way in this scenario.

As such, the Corp would issue the 3rd party a W-2 and include the taxable compensation as salary and the Corp can take the compensation as a deduction. The valuation of FMV could be tricky and it could be an audit red flag, so always consult a tax advisor before taking any action.