The nasty little tax surprise that could be lurking in your granny flat

The nasty little tax surprise that could be lurking in your granny flat

The building of “granny flats” has taken off in many cities, including Sydney.

The relaxing of council regulations surrounding them, including the need for formal council approval, has made their construction easier. Their relatively cheap construction costs, plus potential revenue-earning capability, make them attractive to many people.

But beware – tax issues lurk!

Granny flats can be used for various purposes, for example, for the kids or elderly parents to live in, right through to renting them out on a commercial basis. Their general slab-on-ground construction makes them easy to build, as long as you have a suitably large (and preferably flat) block of land.

So far, so good – cheap to build, good rent prospects, etc. But tax issues need to be considered, especially capital gains tax. And don’t think the Tax Office is not aware of the tax aspects either.

My colleague at Thomson Reuters, Kirk Wilson, a CGT specialist, says a basic scenario could be where a granny flat is built in the backyard or a separate garage is converted into a unit of accommodation for occupation.

In this situation, assuming no commercial type rent is being charged, Wilson says there will be no loss of the CGT main residence exemption under the tax law on any subsequent sale of the whole property. This is essentially because the CGT exemption for the sale of a main residence extends not only to the dwelling but “adjacent land” (as defined) and structures built on it provided they are “used primarily for private or domestic purposes in association with the dwelling”.

Wilson suggests this basic scenario would be covered by this rule even if the “granny flat” occupants were paying outgoings such as electricity, rates, repairs, etc.

But in the case where the granny flat occupants were paying commercial rent, then presumably only a partial CGT exemption would apply on the basis that the main residence (which includes any “adjacent land” i.e. the granny flat) was being used for income-producing purposes.

Moreover, if, under the tax law, this amounts to a “first income use after 20 August 1996”, then the partial capital gain or loss would be calculated under a specific provision of the tax law which requires a determination of the home’s market value at that time of first income use – with any capital gain or loss essentially being calculated by reference to that market value cost at that time and any capital proceeds received, subject to an apportionment for the extent to which the property has been used for income-producing purposes.

Wilson notes this calculation is usually done on an area and time basis so that if, for example, the income use amounts to only 10% of the area of the property and only occurred for two years until the sale of the property 10 years later, then any assessable capital gain or loss would be apportioned by reference to this 10% income use for two out of the 10 years (i.e. by 1/10th x 2/10ths, i.e. 2/100ths) and any capital gain would be also entitled to the 50% CGT discount as the property has been owned for more than 12 months.

Otherwise, any partial capital gain or loss in this case is calculated by reference to the original cost base and capital proceeds apportioned, likewise, in the above manner. As you can see, CGT can get complicated.

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