With rising house prices and a population aging at an increasing rate, it is becoming increasingly common for home owners to construct self-contained living quarters on their properties, typically for occupation by close relatives, or in some cases for commercial rental purposes. Despite often being referred innocuously as “granny flats”, there are numerous tax headaches which could arise from these arrangements.

Income tax matters

Capital gains tax – Main residence exemption

Perhaps the fundamental question to be asked is whether the main residence exemption (MRE) is preserved on the eventual sale of the entire property, where the property includes a granny flat that has been occupied by relatives or third parties.

No rent charged 

In the simple case where occupation is by relatives for no rent, it appears settled that the MRE should apply to the entire property (including the granny flat) as the exemption applies to “adjacent land”, which includes land used primarily for private or domestic purposes in association with the dwelling. Allowing family members to occupy the granny flat for no rent should mean the purpose remains private or domestic.

Rent charged 

In situations where rent is being charged for use of the granny flat, the position is that only a partial MRE applies on the basis that the property has been used for an income-producing purpose. That is, on the eventual disposal of the premises, a capital gain tax liability arises to the extent that part of the property was used for income producing purposes. 

Subdivision scenario

What happens where the land on which the granny flat stands is subdivided from the original property, and is later sold to a third party? In this case, the MRE will not apply to the flat, as the subdivided land will not be “adjacent land”. It is a separate asset which is no longer part of the main residence.

Occupiers of home move into granny flat

As a variation on the previous scenario, consider what happens where the owners of an original dwelling subdivide, build a granny flat or other small residence on the new block, then move into the new residence, and rent out their original dwelling. CGT considerations include:

  • whether the “absence concession” can apply in respect of the original dwelling;
  • whether the “building concession” can apply in respect of the new residence.

The absence concession could be applied so that the original dwelling remains the main residence (instead of the new residence). This can be for a period of up to 6 years if the original dwelling becomes income producing, or for an indefinite period otherwise.

If instead the new residence is to be treated as the taxpayer’s main residence, then the building concession might be applied. There are effectively two exemptions to be considered here. The first allows for 2 residences to be maintained effectively for up to 6 months where there is a change of residences. The other exemption applies where a new residence is being constructed, and allows the main residence exemption to apply for the shorter of 4 years before the new residence actually becomes the taxpayer’s main residence, or the period starting when one acquires an ownership interest in the land and ending when the dwelling becomes the person’s main residence. The original dwelling will cease to qualify for the MRE when the new residence begins to be treated as the main residence. Under this exemption, the original dwelling will cease to be the main residence at the time the owner moves into the new residence, and the new residence will then become the main residence.

Assessable income considerations

Where the granny flat is let out at commercial rates to third parties such as students, rental income will be assessable income (with deductions available).

Creating an asset even where no subdivision

Main residence exemption issues aside, potential CGT events arise where the owner of the property grants the occupier either a right to reside in the property or a life interest in the property.

Whilst often overlooked, these can have significant CGT implications, particularly as the parties are typically not dealing at arms’ length, so the potential is for the market value substitution rules to apply to deem capital proceeds to be received despite there being no payment for the right or interest created. The irony is that by giving parties greater certainty about their entitlements, this will often give rise to adverse tax consequences, whereas leaving arrangements more open and uncertain may have fewer tax implications. It leaves the parties often in an undesirable position of having to decide between relying on each other’s goodwill, and having to address adverse tax outcomes.

The message ultimately is that clients need to carefully consider the structure, and balance the various issues – certainty, flexibility, tax implications, etc – before entering into these arrangements.