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Will you lose CGT exemption by renting out your granny flat?

By Andrew Hayes, Director, Westlawn Business Services
14 April 2014

The range of granny flat scenarios in Australia is quite extraordinary – from the garden variety to homeowners building granny flats in their backyards and leasing them out, almost like a business.

While it may not be possible to deal with all possible scenarios, let’s look at the capital gains tax (CGT) consequences of some basic granny flat scenarios. Specifically, the tax concession which allows homeowners to sell their home tax-free – this concession is known as the “CGT main residence exemption” which I discussed earlier in Do you have to pay capital gains tax when selling a home?

Family backyard granny flat

One basic scenario is where a granny flat is built in the backyard or a separate garage is converted into accommodation for occupation by, for example, adult children, elderly parents or in-laws.

Assuming no commercial-type rent is charged, there’ll be no loss of the CGT main residence exemption on any subsequent sale of the whole property.

Essentially, this is because the CGT exemption for the disposal of a main residence extends not only to the dwelling, but also to “adjacent land” and structures built on it provided they are “used primarily for private or domestic purposes in association with the dwelling”. This rule would cover this basic scenario even if the granny flat occupants were paying outgoings such as electricity, rates and repairs.

Commercial rent from granny flat

However, if the granny flat occupants were paying commercial rent, then a partial tax exemption would apply on the basis that the main residence (which includes any adjacent land) was being used for income-producing purposes. That is, there would be a CGT liability for that portion of the property used for renting out the granny flat.

The CGT liability is usually calculated on an area and time basis. If, for example, the income use amounts to only 10% of the property area and only occurred for 2 years until the sale of the property 10 years later, then any assessable capital gain or loss, say $100,000, would be apportioned by reference to this 10% income use for 2 out of the 10 years – ie 1/10th x 2/10ths, being 2/100ths – resulting in an assessable capital gain of $2,000 which would be also entitled to the 50% CGT discount as the property had been owned for more than 12 months.

This calculation is for illustrative purposes only. Real life will always throw up more complexities. For example, tax law will require you to know the market value of the property at the time the granny flat was first used to produce income.

Even in this case, where commercial rent is charged, it may be possible to argue, depending on the circumstances, that no partial exemption applies – that is, the full exemption applies.

This is because the main residence exemption extends to adjacent land “to the extent that the land was used primarily for private or domestic purposes in association with the dwelling”. The phrases “to the extent” and “primarily” may encompass the case where a granny flat is rented at commercial rates for a limited period (at least in relation to the total ownership of the property) – especially if rented to family members.

Other points to note about these basic scenarios:

    • Where parent(s) move out of the main residence and let their children or a child and their spouse occupy the main residence as their home, then presumably the CGT main residence exemption will be available on any subsequent sale as it appears the basic requirements for the exemption will still be met – provided the parent(s) remain the legal owners of the property. Alternatively, the “absence concession” in the tax law would be available to validly preserve the exemption.
    • If the land occupied by the separate granny flat is subdivided and sold (eg to the occupiers), then no CGT exemption would apply to any capital gain or loss made on the sale.
    • In the related situation where a room in a dwelling is rented at commercial rates (usually to a non–family member), a partial exemption for income use will apply.

Holiday homes & granny flats

The range of granny flat scenarios is unlimited due to the variety of family lifestyles and legal uses of land that can occur. So, there can be as many CGT (and other tax) implications of the arrangements (including land tax) as there are granny flat arrangements.

Take, for example, the situation where a couple owns a holiday home on the coast or in the country, and local council laws permit the building of another structure for accommodation on the land (say for a parent-in-law or adult child working in the region). Assume the couple owns a dwelling elsewhere which qualifies as the main residence for CGT exemption purposes.

What would be the CGT and tax implications in this situation?

It would seem the building of the structure would amount to a capital improvement to the land, the cost of which would be added to the cost base of the land for the calculation of any subsequent CGT liability on the disposal of the land – despite the fact the structure qualifies as a unit of accommodation which has become the main residence of the occupier.

In this case, a key consideration is the fact that the CGT main residence exemption is only available if the occupier has an “ownership interest” in the dwelling, which is clearly not the case here.

In the granny flat business

There is a growing phenomenon where people build granny flats in their backyards for letting out commercially. In these cases, the rent would be assessable income, relevant deductions would be available and a partial CGT exemption would apply on any subsequent disposal of the dwelling on the basis of income use.

In certain cases, the ATO may regard such “enterprises” as a business activity – and require profits and losses to be accounted for on a business basis.

For advice on your particular situation, contact your Westlawn Business Services Accountant.

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Disclaimer

Westlawn Business Services Pty Ltd provides this information for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers.

Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation.