Duncan Hughes* says a Tax Office crackdown on capital gains could have implications for property owners planning to build a granny flat.
Photo: Lachlan Gowen
The Federal Government has ordered an investigation into capital gains tax (CGT) paid on popular granny flat arrangements between grown children and their parents in a bid to prevent tax evasion and to protect elders from abuse.
It comes amid warnings from tax experts about traps that could snare property owners who decide to boost their income, property value or provide accommodation for a relative by building a granny flat.
Many stumble into tax problems because they ignore (or are unaware of) potential tax liabilities at the outset, resulting in a nasty surprise when they declare their income or sell.
“It is something that needs planning,” says Mark Chapman, director of tax communications for H&R Block.
In addition to income tax on rental returns, there is the prospect of GCT and, in limited circumstances, goods and services tax (GST).
Some taxes, like capital gains, are a “slow burn”, adds Chapman.
“It is a tax issue that only comes to light years after the transactions actually occurred — hence the need to be proactive and get advice before actually undertaking the transaction,” he says.
Those planning eventually to sell a granny flat should check with their accountant about potential legal traps and demand for this type of property in the local area.
Most granny flats are built as extensions to the family home, which means once they are built the land cannot be subdivided into separate titles or sold as a separate property or strata title.
Those building a full-sized granny flat dwelling that they might later want to sell are advised to split the property title, then build on the new empty lot.
A flat rented to granny (or another relative) for a nominal amount, says Chapman, would not be regarded as a commercial transaction and neither income nor expenses would be taxable or deductible.
It becomes more complicated if rented to third parties or where taxable commercial rents are charged.
Expenses incurred in running the flat — such as a proportion of utility bills and land taxes or borrowing costs from the construction of the flat — are deductible.
It might generate a taxable profit — or loss to claim against other income — depending on the circumstances.
CGT
There’s also the risk of capital gains on the main residence, which is normally exempt.
Take as an example a house purchased for $300,000 in 2005 and sold for twice the price 10 years later.
In 2010 a granny flat worth $150,000 and occupying one-sixth of the total area was built and rented to a third party.
That means one-sixth of the gain arising from 2010 to 2015 ($150,000/6=$25,000) will be liable for capital gains, says Chapman.
This example is illustrative and to avoid complexity excludes deducting the granny flat’s construction costs.
Chapman says CGT deductions are based on the size of the granny flat and its age.
A flat that hasn’t been rented out and is an integrated part of the family’s lifestyle could also qualify for the main residence exemption, he says.
Another potential CGT liability arises if elderly parents living in the granny flat have an agreement ensuring secure accommodation for some form of payment.
Typically, the parents transfer the title of their house, or proceeds from the sale of the house or other assets, to an adult child in exchange for ongoing care and housing.
A formal agreement means the homeowner may have to pay CGT on the amount paid by the parents, says Chapman.
The CGT event happens when the contract is signed and will need to be paid in the next tax year.
“The agreements are intended to provide security for parents and avoid them being turfed out if, say, there is a relationship breakdown,” he says.
“But it can cause headaches and the CGT issue has deterred formal family agreements.”
The Federal Government has asked the Board of Taxation to review the tax treatment of these arrangements and recommend any changes that would encourage families to enter formal family agreements involving accommodation.
GST
Some property investors who build a flat in their backyards with the intention of a sale might need to apply for an Australian Business Number (ABN) and pay GST under recently introduced tax laws intended to stop fraud in the building industry.
“The good news is most people do not have to worry about GST when it comes to granny flats or additional stand-alone buildings on an existing residential site, for grannies or other relatives,” says Ken Fehily, Director of Fehily Advisory.
Buildings or renovated properties sold five years after construction will not be liable for GST, he says.
“The only scenario where there is a GST situation is where new residential premises were built and sold within five years of construction,” Fehily says.
The following example illustrates the tax impost for a property where the granny flat was built, rented for three years and sold within five years.
A new residence sold within five years of construction for, say $200,000, will face 10 per cent GST based on the sale price less the cost base, which is called the margin.
If the cost of the land was $90,000, the GST, including tax concessions, is $10,000.
The owner can claim back 87 per cent of the first $5,000 of the $55,000 construction costs as a refund.
No GST is payable on the rent of $10,000 a year for three years, or $30,000.
So the total tax bill will be around $5,650.
“That’s a good profit on the rent and sale on land that was worth $90,000 when building started,” says Fehily.
“Yes, there is GST registration to do and the developer will have to lodge quarterly GST business activity statements and keep records.”
Granny flats may be rented out in Western Australia, the Northern Territory, Tasmania, NSW and the ACT, but cannot be offered as rental apartments in Queensland, Victoria and South Australia.
There are also rules about how big a granny flat can be based on the property size.
Requirements for planning permits and approvals also vary between States.
* Duncan Hughes writes on real estate for the Australian Financial Review in Melbourne. He tweets at @duhughes.
This article first appeared at www.afr.com.
