Executive Summary

This paper explores the proposal to permit and incentivize second mortgages specifically for homeowners seeking to build self-contained in-house apartments (“accessory dwelling units,” or ADUs) within existing single-family homes. It examines how such a policy could expand housing supply in constrained markets, the potential risks to financial stability, and the implications for homeowner tax incentives. The analysis finds that, if carefully structured, this approach could contribute meaningfully to easing housing shortages, broaden access to affordable rental housing, and increase homeowner income streams—while requiring prudent regulation of underwriting standards and thoughtful alignment with property tax and income tax rules.

1. Introduction: The Housing Supply Crisis and the Underused Asset

Many metropolitan areas face acute housing shortages, driven by demographic growth, restrictive zoning, and a lagging construction pipeline. At the same time, a significant proportion of America’s housing stock remains underutilized: large single-family homes occupied by smaller households. Enabling homeowners to finance and build self-contained in-house apartments through second mortgages could unlock this latent capacity. These units can meet growing demand for affordable rental housing without requiring large-scale new developments.

Current barriers include zoning restrictions, high upfront costs, and lack of specific financing mechanisms that recognize the future rental income as part of underwriting. A dedicated policy to support second mortgages for this purpose could address these constraints.

2. Policy Proposal: Dedicated Second Mortgages for In-House Apartments

The proposed policy framework would:

Explicitly authorize lenders to issue second mortgages to finance the construction or conversion of in-house apartments. Provide federal, state, or municipal backing or guarantees to reduce lender risk. Permit lenders to consider anticipated rental income from the apartment as part of repayment capacity assessment. Establish uniform underwriting criteria to prevent systemic risk while encouraging uptake.

The loans would remain subordinate to existing first mortgages, as with traditional second liens, but tailored to the unique use case of ADU creation.

3. Implications for Housing Supply

a) Quantitative Impact

If even a small fraction of eligible homeowners in constrained urban and suburban areas created in-house apartments, the effect on housing supply could be substantial. For example, in a hypothetical metro area with 1 million single-family homes, a 5% adoption rate could add 50,000 rental units — comparable to years of new multifamily construction.

b) Affordability Gains

In-house apartments typically rent for less than newly built market-rate apartments due to lower construction costs and absence of land acquisition costs. This could improve access for middle- and lower-income households.

c) Neighborhood Character and Density

While adding density, in-house apartments generally preserve the appearance and scale of neighborhoods, minimizing opposition compared to large multifamily projects.

4. Tax Implications and Incentives

a) Income Tax Considerations

Homeowners would report rental income, subject to ordinary income tax. However, they would also gain access to deductions for mortgage interest, property taxes (subject to current SALT limits), depreciation, and a share of utilities and maintenance allocated to the rental unit.

Policymakers might consider enhanced deductions or credits (e.g., for construction costs or accelerated depreciation) to incentivize participation and offset initial tax liability.

b) Property Taxes

Creation of an in-house apartment could increase assessed property value and property taxes. Some jurisdictions may wish to exempt the incremental value for a period of years to encourage uptake, or cap increases to avoid deterring participation.

c) Capital Gains

Careful guidance would be needed regarding the treatment of capital gains on eventual home sale, particularly if the home has been partially depreciated and partially used as rental property. Preserving homeowner access to the primary residence exclusion would be important to avoid unintended disincentives.

5. Risks and Mitigation

While the proposal has clear benefits, it also carries risks that must be addressed:

Credit Risk: Borrowers may overestimate rental demand or income, leading to repayment difficulties. Mitigation: conservative rent assumptions in underwriting. Overleveraging: Second mortgages increase homeowner leverage and default risk. Mitigation: limit loan-to-value (LTV) ratios and require sufficient equity. Regulatory Fragmentation: Varying local zoning and permitting rules could undermine effectiveness. Mitigation: coordination with municipal land use reforms to allow ADUs by right.

6. Recommendations for Implementation

Federal Backing: A federal guarantee program (similar to FHA Title I) specifically for in-house apartment second mortgages could spur private lending. Model State Legislation: Uniform standards for underwriting, tax treatment, and tenant protections should be developed for adoption by states. Local Zoning Reform: The financing initiative must be paired with zoning changes that legalize and streamline permitting of in-house apartments. Public Awareness Campaign: Homeowners will need clear, accessible information on the financial, tax, and regulatory aspects of creating an in-house apartment. Tax Code Adjustments: Amendments to federal and state tax codes to ensure favorable treatment of rental income, mortgage interest, and property tax deductions can enhance the program’s appeal.

7. Conclusion

Permitting and supporting second mortgages to finance in-house apartments offers a promising, decentralized response to the housing shortage. By leveraging the existing housing stock and private capital, the policy can expand affordable rental supply with minimal public expenditure and without radically altering neighborhood character.

A successful implementation requires coordination between lending institutions, tax authorities, and local governments to ensure legal permissibility, financial prudence, and homeowner incentives align. Thoughtful design of underwriting criteria and tax rules will help mitigate risks and maximize benefits, making this a practical and scalable policy solution.

Prepared by:

[Nathan Albright]

[Torah University Press]

[July 18, 2025]