Apportioning CGT Between Granny Flat and House

Question

I wrote to Noel Whittaker and he suggested that you might be someone who could assist us.

My husband (84) and I (77) are planning to build a “Granny Flat” in our back garden which we intend to move into, as we feel we will need a level one storey villa as we become less active, and it is our intention to rent out our existing home, on the same block, mainly furnished.

Our local council in Melville, Western Australia is very happy for us to build this as they are keen on infilling and a far as we know, we don’t even need planning permission so long as the property is no larger than 70 sq mts and has enough car parking space for three cars (our prospective builder, Dale Alcock, has checked this with the council). The council appear to consider the Granny Flat as an ancillary part of the main property even though it will be a separate building.

We will use some of our superannuation to do this and realise that we will possibly have to pay tax on the rental income. Could you please tell us what implications there may be regarding Capital Gains Tax when the entire property (main house and Granny Flat) is sold either by ourselves or our beneficiaries at some time in the future.

We have spoken with our accountant who mentioned that there is a possibility of moving back into our main residence within six years and thereby avoiding any CGT. If after six years we are happy to continue living in our Granny Flat then we or our heirs would have to pay the CGT on the sale of the property I presume. Our accountant advised us to have the main house valued when we move into the Granny Flat and he says that the CGT will only be paid on the difference between that valuation and the value at point of sale.

Do you have any further input to add about this situation?


Answer

The big question is whether you have one dwelling or two.   TD 1999/69 is the key ruling on this https://www.ato.gov.au/law/view/document?locid=txd/td199969/nat/ato   You don’t stand a chance of it being consider the one dwelling unless you live in both properties as your home initially.  On what you say it seems you will have to treat the property as two separate dwellings.  You are only allowed to cover one dwelling with your main residence at a time.

After you build the granny flat you will have two separate assets for CGT purpose and the land will be apportioned between those assets.  You can decide how much land goes with each property but obviously the land immediately underneath each dwelling goes with it.

You could move into the granny flat and move back into the main house after 6 years live there as your home and move out again for another 6 years etc that would always cover the main house with your main residence exemption but of course the granny flat would always be exposed to CGT.   You will need a valuer to apportion the price you eventually get for the property between the house and the granny flat.

When you first use the original house to produce income ie rent it out, then assuming until that date it has been fully covered by your main residence exemption then section 118-192 ITAA 1997 will reset the cost base of that part of the home to market value at date it first earned income.  It is important to realise that this reset will only apply if you sell it in your life time.  Otherwise, in your estate, it will revert back to the original cost base and apportionment between time covered by your main residence exemption and time not.   With lots of record keeping necessary for the whole time you owned it.

I am assuming you have owned the original property from longer than 4 years.  It is important to be aware that the land under the granny flat will lose its attachment to your main residence exemption back to the time you first purchased the property.  I am also assuming the granny flat is never rented out.    Let me just sew that thought and I will try and explain better by way of examples:

Example 1 – Choose to maximise the main residence exemption on the original home and you sell the whole with in your life time.

     This would come about by either selling within 6 years of renting the original home out or moving back and resetting every 6 years.  You would apportion very little land to the granny flat.  So no CGT at all on the portion of the selling price that is attributed to the original house as covered by your main residence exemption.  The CGT on the granny flat would be calculated by looking at the size of the land attributed to it and what portion that was of the original purchase price of the whole property.  Add to this the cost of building the granny flat, any other improvements etc its share of buying and selling costs.   This is your cost base but section 110-25(4) ITAA 1997 will also allow you to increase your cost base by holding costs as long as they don’t go so far as to create a capital loss.  Holding costs are rates, insurance, repairs, interest even cleaning materials that have not been claimed as a tax deduction.

Example 2 – Choose to not worry about the 6 year back and forward and just allocate your main residence exemption into either property on the basis of which one you are living in.

     The granny flat cost base will be calculated as above but your own home (assuming sold in your lifetime) will get to reset its cost base to the market value when it first started to produce income.   Then it is just a matter of apportioning each gain between days covered by the main residence exemption and days not.  This may mean that the only CGT liability on the granny flat is the gain from purchase of the land until you moved into the granny flat.  The CGT on the house may only be the difference between the market value when first rented out and its portion of the selling price less selling costs.  But if it is the estate that sells it then both dwellings (not just the granny flat) have to go back in their CGT calculation to the original purchase price apportioned between the dwellings and the selling price similarly apportioned then the gain on each dwelling apportioned on the basis of how many days covered by your main residence exemption verses how many days not.

One thing for sure is you can’t use the 6 year rule to cover both dwellings because they are separate dwellings and you can only cover one.

A little trick if you can manage it, though you have to die to pull it off.  When the last of you die they could be spreading themselves between both dwellings using as their home.  Maybe children living there to help with care but no rent being paid.  Then it would be considered to be the remaining spouse’s home over both dwellings and section 128-15 would allow it to be inherited by your heirs at market value at DOD, the CGT nightmare forgotten.

Please make sure you take this answer to your Accountant to have it explained by someone with a better understanding of your circumstances and preferences.

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