We own a 925sqm block with an existing house. We bought this property in 2001 and have lived here since. I am 56 and my wife is 57. We intend to retire when I am 60 in April 2017. Post retirement we plan to move overseas and live there for five years till I am 65. At that point we will return to Australia to live. It is possible that we would return for short visits in between or cut short our stay and return earlier.
We plan to build a granny flat this year and we intend to rent it out until April 2017. We would like you to consider a few scenarios on our behalf and provide us with advice in relation to tax implications. We expect the granny flat to cost around $110,000 and expect a rental return of $350 p. w. minimum
1. Between now and 2017 if we rent the granny flat, will the property be considered PPR until April 2017. I am aware that we will pay CGT on the granny flat as a proportion
2. When we leave Australia in 2017, if we rent the main house and leave the granny flat vacant what are the CGT implications and are we eligible for the CGT exemption on PPR.
3. When we leave Australia in 2017, if we rent the main house and the granny flat what are the CGT implications and are we eligible for the CGT exemption on PPR.
4. On our return we may choose to live in the granny flat to realize a better income from the main house. What are the CGT implications down the track if we chose to sell or our children inherit.
5. On our return does it make sense to live in the main house and rent the granny flat assuming occupancy of 10 to 15 years.
6. Does it make sense to invest in a granny flat at all in these circumstances?
Here is a link to an ATO ruling where they discuss the fact that a granny flat can be considered an extra dwelling so only the home or the granny flat can be covered by the main residence exemption. http://law.ato.gov.au/atolaw/view.htm?locid=txd/td199969/nat/ato
This is definitely something you want to avoid. So the idea is that when you first build the granny flat you must use it as part of your home. Maybe send teenage children to live in it but make sure they come back into the house for dinner so that the two buildings combine to be the whole family home, or you may use it as a studio for some hobbies. If you establish it as part of your home right from the start then this status does not change and when you rent it out it is treated the same as when you rent out rooms in your home. Because up until that time the whole property had been covered with your main residence exemption the first time you earn any income from the property the cost base of the whole property is reset to the market value at that date, section 118-192. This is important, if you don’t trigger this reset then the land under the granny flat starts with the cost base of its cost back in 2001.
Section 118-145, the absence rule, this allows you continue to cover your main residence with the CGT exemption when you are not living there. So it is no use to you while you are living in the house and renting out the granny flat or vise versa because you are not absent from the property. During these times the capital gain will be apportioned (examples are shown below) between the area that is income producing and the area that is not and by the number of days it is not covered. The trick is when you go overseas, because you are absent you can cover both the house and the granny flat (providing as discussed above its starts life as part of your home) with your main residence exemption for up to 6 years while you are away from it. It is all a matter of how it was used just before you move out. So before you go overseas you need to use both the house and the granny flat as your home then rent them both out at the same time as you leave. Coming home and living in just one side and then going away again will mean then that only the portion of the property that you lived in will be protected by your main residence exemption from the day you moved back in and continue that way while you are overseas the second time.
Of course you can rent out the house and leave the granny flat vacant and still cover both with your main residence exemption providing the whole property was used as your home just before you leave to go overseas but there is not much point to that because you are going without all that rent and if you did return for a short visit it would mess up your main residence exemption, next time you leave only the granny flat would be covered unless you kick the tenants out of the main house and use the whole property as your home for a while anyway.
Whether you are living it the house or the Granny flat only makes a difference to the percentage of the whole property that is considered to be income producing, usually calculated on floor area.
The ultimate CGT trick is to die in the property using both the house and granny flat combined as your home. Again providing you used it as part of your home when you first built it then the whole property will be considered your home at date of death which means your heirs inherit it at market value at the date of your death so any CGT that would have been payable in your life time is gone, forgotten and forgiven!
Please do not act on this advice without first discussing it with an accountant who is fully aware of all your circumstances.
Here is an article I wrote for Australian Property Investor Magazine a few months back.
The CGT Consequences of Putting A Granny Flat In Your Own Back Yard
Building a Granny flat in your back yard can reduce the area covered by your main residence exemption even if it does not produce income.
It is all a question of whether the Granny flat is a separate dwelling from your home. This has nothing to do with the structure or design but simply how the Granny flat is used. In fact it boils down to how many times you visit Granny!
In TD 1999/69 the ATO gives the following examples of the difference between the Granny flat being used as part of your home or considered a separate dwelling:
7. Mary decides to build a duplex. Mary lives in one unit and her 30 year old daughter, Elizabeth, lives in the other. There is a connecting door from one unit to the other via the garages with Mary and Elizabeth having unrestricted access to each other’s unit. They generally use the main entrance to each other’s unit. Mary and Elizabeth have dinner together usually once a week. Mary maintains the whole of the surrounding garden. All other costs of maintenance and other costs of the duplex are paid separately.
8. Each unit is a separate ‘dwelling’ in terms of section 118-115 because Mary and Elizabeth use each unit as a separate place of residence.
This means that when Mary sells the duplex even if both units are sold to the same person she will only be able to cover her ‘dwelling’ with her main residence exemption and will be subject to CGT on the area her daughter lived in. This appears to be the case even though Mary’s daughter didn’t actually pay rent but did pay the expenses associated with her side.
Here is an example from the ruling where the ATO decided there was only one dwelling ie the main residence exemption could apply to the whole property:
6. Mr and Mrs Brown reside with their three children in a suburban house. Mrs Brown’s mother (Dora) resides in a detached granny flat built for her in the backyard. Although the flat is fully self-contained, and Dora eats and sleeps there, Dora’s daily life and activities are closely integrated with those of the Browns. She spends considerable time in the main house and family members regularly spend time in Dora’s flat. In the circumstances, having regard to the proximity of the flat and the integration of activities, the house and the flat are the Browns’ dwelling for the purposes of section 118-115.
If you are not even getting rent for the property the last thing you want is to be up for Capital Gains Tax (CGT) on your home as a result of building the Granny flat. It is even worse than this because the land used by the Granny flat will be subject to CGT right back to the day you purchased it. This is another reason you want to keep your main residence exemption over the whole property, so that if you even do receive rent on the Granny, assuming up until that point in time the whole property has always been covered by your main residence exemption, you can reset the cost base of the whole property to the market value at the date the Granny flat is rented. This will lock in all capital gains to date. No chance of CGT applying to the land before the Granny flat was built. To achieve this you need to use the Granny flat as part of your home as per the Mr and Mrs Brown example above for at least 3 months after it is built.
Now it appears (no guidelines available from the ATO) that once you establish the Granny flat as part of your home it will always be considered to be part of your home even if you rent it out. In this case the tax treatment would be similar to renting out rooms in your home as per ATO ruling IT 2167.
Certainly if you are not receiving rent then you want the whole property to be covered by your main residence exemption but if you do eventually rent the property out there will be some exposure to CGT. As the Granny flat is not considered a separate dwelling then its CGT calculation is mixed in with your home. This can be good or bad depending on whether the capital gain on your home exceeds the expenses you can add to the cost base. How much you have borrowed is probably the most relevant consideration. Though there are lots of other expenses you can include if you keep good records. Anything associated with your home, even repairs and maintenance (ie cleaning materials, lawn mower fuel, light globes etc) can increase the cost base of the whole property. Most of these will come from your home because once the Granny flat is rented out you will be claiming its expenses as a tax deduction so they cannot be included in the cost base.
The areas where you are sure to win from having the Granny flat considered to be part of your home are when there has been a capital gain on the land before the Granny flat was rented out and you can use the reset rule. The second positive is that when the Granny flat is not earning income it can continue to be covered by your main residence exemption. Something that would not be possible once it is established that it is a separate dwelling.
The CGT calculation is covered in section 118-190 ITAA 1997. Once the Granny flat is rented out the first element of your cost base is it’s value at that date. You then add to the valuation any costs, after the reset date, that are associated with the whole property. The calculation works to reduce the capital gain on the granny flat with your household expenses. Keeping good records will save you heaps in CGT.
Here is an example of the CGT calculation. Assume the valuation was $600,000 and you rent the property out for 8 of the next 10 years and the area you claim as being for the granny flat is 30% of the property:
Reset market value cost base $600,000
All costs of ownership for the whole property
That has not otherwise been claimed as a tax
Selling costs 20,000
Cost base at time of sale 720,000
Less Selling Price 750,000
Capital gain 30,000
20% of time not a rental 6,000
70% of property covered as main residence 16,800
Taxable Capital Gain 7.200
Less 50% CGT discount 3,600
Taxed at marginal rate 3,600
If instead the Granny flat was considered a separate property then only its costs would be included in the CGT calculation. Let’s assume you paid $300,000 for the house many years ago and a valuer says that the house was worth $100,000 at that time and the land $200,000. The area used by the Granny flat is 25% of the overall land so the cost base for the land under the Granny flat and its surrounds is $50,000. This also means that the land used for the Granny flat is 1/6th of the original property. On sale the valuer determines that the house is worth $500,000 and the Granny flat $250,000 so the Granny flat is 1/3rd of the selling price. The CGT calculation would be as follows:
Land Value $50,000
Purchase costs etc $10,000 / 6 1,667
Holding costs of land over the years ie 1/6th of rates 5,000
Construction cost of Granny flat 100,000
Selling costs 20,000 / 3 6,667
Cost base at time of sale 163,334
Less Selling Price 250,000
Taxable Capital gain 86,666
Less 50% CGT discount 43,333
Taxed at marginal rate 43,333
Of course the difference in the gain largely depends on how much capital gain is in the land since you bought it and whether the costs associated with your home exceed its capital growth. It will all depend on your particular circumstances.
If the Granny flat is used as a rental right from the start not only will you lose the main residence exemption retrospectively on the land under the Granny flat but you cannot use section 118-192 to reset the cost base because they are two separate dwellings.
Whatever you do, do not let family live in the Granny flat in isolation. Again it will be considered two separate dwellings so no resetting of the cost base when you rent it out because that dwelling, the Granny flat, has never been your main residence, Further, even when your family move in to the Granny flat you will not be able to reset the cost base on the property because at that point in time it is not earning income. You will end up with land that was once covered by your main residence exemption now exposed to CGT and not even rental income to compensate.
These problems are just one of the many examples of how Mums and Dads can easily fall into the trap of having to pay CGT because the information they need is just not available to the public. Not only will they end up paying considerable tax because of one small slip up in the way they went about things ie how often they visit Granny in the flat, but not expecting the ATO to have the right to interfere in such a basic family arrangement, they will not have kept records and will not think to include the gain in their tax return. The first they will be aware of the problem is when the ATO contact them a few years after the sale (about the time they decide to throw out all records) with fines and interest charges as well. For that matter it is not just Mums and Dads that lack the information they need. Even the tax profession has not got a clear answer on this one in regard to changing uses of the Granny flat. That of course is no excuse, our tax system is based on self-assessment so it is the responsibility of the taxpayer to make sure they complete their tax returns correctly.