Deductions for building studio/granny flat

Question

We own a 280sqm block with an existing house. We bought this property in January 2011 for $1M.
We rented out the property for the first 18 weeks of ownership.
The property is now valued at $1.1M
We plan to build a garage with a self-contained apartment above (the studio will have 35sqm living area of a total living area of 160sqm). The land under the garage/studio is approximately 50sqm.
After reading your article in Nov 12 API article I have few questions:

1. I understand that developing the granny flat is a capital expense as per PR: 48928, however can I start claiming tax deductions on interest paid on borrowings related to the construction (DA approval, professional fees, construction progress payments etc..) if we intend to rent it immediately upon completion and it is a short build (less than 3 months).

2. If we decide to treat the studio as a separate dwelling can we claim a tax deduction on borrowings related to the land component of the apartment. This seems only reasonable since we stand to pay CGT on the land it is built on. If the land component is tax deductible, 2 further questions:
(a) is the land component based on the OSR unimproved value ($550K) or can it be based on a bank valuation ($850K); and
(b) when can we start claiming interest on the land component (ie. now we are drawing up plans, when construction starts or when it is first rented out).

3. Is it possible to scrap the value of the existing garage and any other fixtures removed as part of the construction (I have a depreciation report from when the property was initially rented out).

4. We intend to own the property for some time and expect a family member will live there at some stage (possibly in 10 years time). Since the property was initially rented out we are comfortable further exposing it to CGT and reduce the CGT impact by all ongoing expenses. Is there anything else we should consider in deciding whether the studio should be regarded as a separate dwelling?

Answer


This is quite an oversized question so I will cut to the chase and refer you to references when I can. I am going to assume you fully understood the API article and the ramifications of treating the granny flat as a rental right from the start, which will be necessary in order to claim interest during construction. You would miss out on the resetting of the cost base anyway because the whole property was first a rental but once it is considered a separate dwelling from your home the untested theory is that it cannot be covered by your main residence exemption even when used as part of your home. How you use it when it is first built determines whether it is a separate dwelling or not.

1) You can certainly claim the interest on the loan relating to the granny flat and the land underneath right from the time you commit the property to the project of creating a granny flat to rent. This is based on Steele’s case and is stated in the ATO’s rental property guide. No 3 months limit just a requirement not to change your mind or stop the project. Delays by council and builders are fine as long as they are simply part of the project not you stopping the project.

Just restating here that in order to claim interest before you put the first tenant in the property you have to treat the Granny flat as a rental right from that point so it will always be considered a separate dwelling from your home which in theory (untested) means the main residence exemption can never apply to it at the same time as you are covering your home.

2) If you have kept the nexus tidy on the original borrowings for the property ie no redraws. Then you apportion the original purchase price between your home and the land being used by the tenant ie under the studio and courtyard etc if applicable and apply this percentage to the original borrowings. Note the value of the garage that seems by your discussion is going to be demolished can still be included in the percentage used to apportion the interest and in the Granny flat’s cost base.
a) Based on portion of original price paid
b) From date committed to the project of creating a rental ie now

3) No as not used to produce income immediately before demolition reference ID 2010/35 http://law.ato.gov.au/atolaw/view.htm?docid=%22AID%2FAID201035%2F00001%22
4) I am comfortable with your choice only the future will prove whether it was the right one, you can see the pros and cons in the article. Just make sure you do section 110-25(4) to death on both properties ie keep records for any expenses you have not otherwise claimed as a tax deduction (ie when the family member lives in the granny flat) even light globes, cleaning materials, lawn mower fuel.
Re anything else to consider – If your current home is covered as your main residence when you die then your heirs will simply inherit it at market value at DOD so the CGT liability for the 18 weeks it was rented out at the start is forgiven and forgotten. So too would all the CGT on the granny flat if it is not being rented out at the time and was initially considered to be part of your home instead of a separate dwelling ie not treated as a rental at the start as per the API article. If there is a possibility you will continue to live in this house in your retirement the scales are now more tipped to try and treat the granny flat as part of the home initially which of course means no interest deduction until a tenant goes in there and the tenant should not go in there upon completion, it needs to be used as part of your home first.

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