Overview: Tim and Danica are IT professionals with 3 kids. Their company allow them to follow hybrid model. They work 3 days from home office and 2 days from their office. Just before COVID Danica’s mom Mel came to live with them and got stuck with them since then. Tim enjoys a wonderful relationship with his mother-in-law, appreciating her culinary skills and valuing her assistance with childcare when both he and Danica are at work. The arrival of a newborn immediately after COVID highlighted the limitations of their living space, which was insufficient to comfortably house everyone. Hence, they decided to build a self-contained granny flat to have Mel be there at her own comfort.
Their home’s proximity to a highly sought-after public school in Melbourne makes their location especially attractive to small families prioritising their children’s education. Tim is contemplating the possibility of renting out the granny flat in, as Mel decided to travel overseas to be with her elderly mother. In light of this, he is seeking advice from Investax regarding the potential tax implications including the capital gain and land tax of these arrangements.
Queries and Challenges:
- Do they have to report the income to the tax office if they rent it out to their close relatives?
- Will Tim and Danica have to pay Capital Gains Tax for the granny flat if they do not rent out the premises?
- Will they be eligible for a 6-year exemption and not have to pay Capital Gains Tax if they rent out the granny flat?
- Will they be liable for land tax if they rent out the granny flat?
Solutions and Outcome of Consultation:
Report Rental Income to the ATO – Tim and Danica are required to report the rental income from their granny flat to the ATO as soon as they begin to earn it. They are also entitled to deduct expenses such as interest on any loan taken to construct the granny flat, as well as a portion of the council rates, water rates, insurances, etc., from this rental income. We have recommended that Tim and Danica review Michael’s case study on room rental to gain insights into how to calculate the apportionment of these expenses.
Capital Gain before Renting the Granny Flat – A crucial consideration in such scenarios is determining the physical separation between the granny flat and the main house. If the granny flat is attached to the main house, meaning they are not distinct structures, it is generally understood that the granny flat should be considered an integral part of the main house for the purposes of the main residence exemption. If the granny flat has never been utilized for income generation, its occupancy by a family member is unlikely to affect the applicability of the main residence exemption.
If the granny flat is physically separate from the main house, then the next step is to determine whether the main house and granny flat are treated as if they were a single dwelling. According to TD 1999/69, if a detached dwelling under a single title is used together as a single place of residence by a family, it will be treated as one place of residence. If you both premises under the single title are treated as their family home, then they will not be liable for CGT.
For example – 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.
Example Source – ATO TD 1999/69
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6 years Exemption and Capital Gain Tax After Renting the Granny Flat
Renting out a portion of their home or the granny flat to earn income means Tim and Danica won’t qualify for the full main residence exemption from Capital Gains Tax (CGT). They are not eligible for the 6-year exemption rule if they are renting out the granny flat. When they sell their property, the portion used for rental is subject to CGT. They can deduct expenses, similar to those of an investment property, for this part as it generates assessable income.
To calculate their assessable capital gain or loss, consider the following factors:
- The proportion of their home’s floor area dedicated to rental use.
- The duration it was used to earn rental income.
- The capital gain or loss on their property from the time they began using it for rental income.
We have suggested Tim and Danica to have their home appraised when they initially use it for rental or business purposes. This valuation will be crucial when they eventually sell the property.
Land Tax Liability – Land Tax varies by state in Australia. Generally, you are not required to pay land tax for a single title multi-dwelling arrangement. However, it’s advisable to consult your respective state’s revenue office for confirmation.
As illustrated by Tim and Danica’s experience, renting out a section of your home or a granny flat introduces complexities with income tax, capital gains tax, and land tax. If you’re considering a similar approach, it’s essential to recognize the value of professional guidance in navigating these challenges effectively. We encourage you to consult your accountant and plan from the beginning, just like Tim and Danica, to fully understand the tax consequences. If you do not have a property tax specialist, please feel free to reach out to Investax Group. Our accountants can help you understand your tax obligations and unravel the complexities to enable you to make informed decisions.
Pro Tips –
- Professional Valuation: Before renting out the granny flat, consider getting a professional valuation of the property. This will be crucial for determining any capital gains tax implications when you decide to sell the property.
- Insurance: Ensure you have the right type of insurance coverage for renting out part of your property. This may include landlord insurance, which covers property damage, liability, and loss of rental income, among other things.
- Rental Agreement: If renting to relatives or close friends, it’s still important to have a formal rental agreement in place. This helps clarify expectations, rent arrangements, and responsibilities, reducing the potential for misunderstandings.
- Document Everything: Keep detailed records of all transactions, expenses, and communications related to the granny flat in an excel spreadsheet and other electronic format. This includes contracts, receipts, and correspondence with tenants and service providers. Accurate documentation can be invaluable for tax purposes and in case of disputes.
- Seek Professional Advice: Navigating the tax implications of renting out a portion of your property can be complex. It’s crucial to consult with a property tax specialist or accountant who is well-versed in real estate investments. For tailored advice and comprehensive support, consider reaching out to Investax. Our expertise can help you understand your obligations, optimize your tax situation, and make informed decisions about your property investment.
Reference
https://www.ato.gov.au/law/view/pdf/pbr/td1999-069.pdf
https://investax.com.au/case-study/room-rental-and-cgt-liability/