As parents grow older, they may require additional care and can find it hard to continue to maintain their own home. To deal with that, increasing numbers are moving into ‘granny flats’ within the homes of their children.
That way, the parent maintains a degree of independent living, whilst having family carers on hand if required.
Unfortunately, these arrangements can also have unforeseen and substantial tax consequences for the children into whose properties the parent is moving.
Here’s H&R Block’s guide to all you need to know about how creating a granny flat can impact your taxes.
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Rent could be taxable
In many cases, the child will look to charge their parent rent for the use of the granny flat. The tax implications of that will depend on whether the rent is set at a commercial level (in other words, the parent is charged a market rent) or whether a reduced or notional level of rent is set.
Where the rental income is set at a commercial level, the rent will be taxable. In addition, any expenses that relate to the granny flat (including a proportion of total household bills that can be apportioned to the granny flat) can be deducted from this rent.
This could potentially include any interest on loans taken to construct or improve the granny flat, plus any part of the main household mortgage that relates to the granny flat. This might create a tax loss that can be offset by the child against their other taxable income.
Where the rent charged is set at a nominal level, the rent will be still taxable but deductions will be restricted to the level of rent received (so that a loss cannot be created).
What about Capital Gains Tax?
Normally, your main residence will be exempt from capital gains tax (CGT) when you dispose of it but putting a granny flat on your property may mean that part of the profit on sale will become liable for CGT.
This will be the case if you earn taxable rental income from the granny flat. This will mean that a capital gains tax calculation will have to be done for the whole property with an apportionment done between the main residence and the granny flat with tax potentially payable on the granny flat element.
The CGT would be based on how much space the granny flat takes up. You would also need to consider how long the granny flat has been in existence.
If you owned the property for 10 years but the granny flat was only built 5 years ago, you don’t need to worry about CGT on the first 5 year period.
If you can demonstrate that the granny flat space is an integrated part of the household lifestyle, you may be able to argue that the main residence exemption should cover the granny flat too.
My parent will pay me to secure the right to live in my house. Is that amount taxable?
In a typical granny flat scenario, the parent might sell her own home. Using some of the proceeds, the parent will then pay a substantial sum of money to her son or daughter for the right to live in a granny flat within the property of the child for the rest of her life.
Often, both parties will put in place a legal agreement to formalise the arrangement and to provide protection to the parent in the event that the child divorces or passes away.
Unfortunately, under current law, the cash sum paid creates a CGT liability falling on the son or daughter. The 50% CGT discount is not available and there is no base cost to offset the proceeds, so the entire amount is subject to tax.
Very often the son or daughter will only become aware of the tax issue long after the arrangement has been put in place, when it’s too late to do anything about it.
However, change is on the way. In the last Federal Budget (in October 2020), the Treasurer announced that an exemption from CGT will be introduced for granny flat arrangements where there is a formal written agreement between the parent and the child (in other words, exactly the scenario described above).
However, this measure has not yet come into effect, so at the time of writing, CGT is still a very real issue.
The measure will have effect from the first income year after the date of Royal Assent of the enabling legislation. It isn’t clear when that will be (the timing is in the hands of the government) but it could be as soon as 1 July 2021.
Any other advice?
Remember, most of the tax risks with granny flats fall on the children into whose home the parent is moving, not on the parent.
Whilst granny flat arrangements can suit the lifestyles of all involved, it is essential to take tax and legal advice before doing anything so that all parties are fully aware of their liabilities and can plan around them.