Granny flat tax implications

‘Granny flat’ arrangements are widely considered as an option to provide elderly parents companionship and care. More often than not, these are informal family arrangements.

While the word ‘granny flat’ refers to accommodation in the family home’s backyard, a granny flat arrangement refers to the payment of money or assets for the right to live in someone else’s (usually a child’s) home. Valuable assets, such as the parent’s home, may be sold to pay for the right. In some cases, the title of the home is transferred to the person providing the right (grantor). Additional funds may also be given as consideration.

A financial adviser would naturally investigate the arrangement’s impact on the clients’ Centrelink or Department of Veterans’ Affairs (DVA) pension entitlements. However, the consequences can be broader than just these over the long-term.

Most arrangements are entered into with the best of intentions and each party will have their own expectations from the arrangement. However, it’s best to look at the practical implications for everyone affected before entering into such an arrangement. Difficult questions must be asked.

What is the state of the elderly parents’ physical and mental health? Is it expected to change over the short to medium term? Will the child provide all the required care, or will community or home care also be needed? Will the child have to take time off work to provide care? If so, how will this impact the child’s income and career? Will the child and their family cope with caring for the parent over the long-term as care needs increase? What will happen when proper care can no longer be provided at home or either party decide that the arrangement does not work? What are the provisions for the parent’s accommodation if the home is sold such as in the event of foreclosure by a lender, bankruptcy or relationship breakdown?

When paying for a granny flat arrangement the parent should consider their own personal needs and ensure that they will still have enough funds if they ever need to enter residential aged care in the future. In addition, they should review their estate planning arrangements as a significant transfer of their estate to one child may cause discontent amongst other potential beneficiaries. It’s important to discuss the arrangement with family and reach an agreement to reduce future challenges which might end up in court.

While many arrangements are informal, there may be merit in having a formal arrangement to protect the interests of both parties. This requires them to enter into a legal contract. An important consideration with granting a legal right to occupy is the capital gains tax (CGT) impact on the grantor.

Since 1 July 2021, eligible formal non-commercial granny flat arrangements are exempt from CGT.

To be eligible, the individual conferred with the right to occupy a dwelling for life must satisfy one of the criteria at the time the granny flat interest is conferred:

• They have attained their age pension age, or
• They require assistance with carrying out most day-to-day activities due to a disability and this assistance is likely to continue for at least 12 months. The individual does not need to be eligible for the Disability Support Pension, but generally an individual who is eligible would satisfy this criterion.

For a formal arrangement to benefit from the CGT exemption, it must not be of a commercial nature. While not conclusive, an indicator of a commercial arrangement would include the payment of market rate rent. Whereas if the individual does not pay any rent, or only contributes to household running costs, this suggests a non-commercial/private arrangement.

The exemption from CGT will apply to CGT events which occur on or after 1 July 2021, even if the arrangement was entered into before this date (however there is no relief for previous CGT events which have occurred prior to 1 July 2021). The CGT exemption is designed to encourage the formalisation of granny flat arrangements as this provides certainty for the long-term housing arrangements of older and disabled Australians. 

CGT consequences for the grantor of a right of occupancy

The following CGT consequences are the rules that apply to individuals who are not eligible for a granny flat interest for CGT purposes as described above. One example is where an individual conferred the right to occupy a dwelling for life is under age pension age and not disabled.

CGT event D1 happens when a legal right to occupancy is granted. A right of occupancy is a right to live in a property for life or for a certain term. A right of occupancy doesn’t include the right to income from the property (as in a legal life interest). According to Tax Ruling TR 2006/14, a grantor realises a capital gain/loss if the payment for the right is more or less than the incidental costs of creating the right. As the parties are not arms-length the grantor is taken to receive capital proceeds equal to the market value of the right if payment is more or less than market value. However, if there’s no payment at all, no capital gain or loss arises.

Market value is usually determined by a valuer and based on factors such as the location and type of accommodation, as well as the life expectancy of the person subject to the right (or the agreed term).

Incidental costs may include fees paid to an accountant, valuer and/or legal adviser for services relating to the granting of the right and excludes any costs (including incidental costs) to acquire the property in respect of which the right of occupancy is granted. The grantor cannot use the main residence exemption to exempt any capital gain for CGT event D1.

The cost base for the person acquiring the right (grantee) is generally the total value of assets and/or any money paid for the right. However as the parties will not be dealing at arms-length, the grantee will be taken to have paid market value if payment is more or less than market value. If no payment is made at all, the grantee will be taken to have paid nothing. If the grantee subsequently dies or disposes of the right to occupy the property, there are no CGT consequences as the main residence exemption will apply.

Example: Capital gains tax consequences for grantor of mere right to occupancy

Annie, aged 64, transfers her home which is valued at $700,000, to her daughter Mary. Mary grants Annie a lifetime right of occupancy in her home and agrees to take care of Annie for as long as she lives. Annie does not suffer from any disability which involves the need to assist her with most of her day-to-day activities.

Mary engages the services of a valuer, accountant and lawyer to formalise the agreement. The valuer determines the market value of the right of occupancy to be $250,000 and is paid a fee of $5,000. The lawyer discusses the implications of the arrangement with the family and draws up a contract to evidence the granting of the right and family agreement. He charges a fee of $7,000. The accountant advises on the tax consequences of granting of the right and is paid $3,000. Incidental costs of creating the right total $15,000.

As the parties are not dealing at arms-length, Mary’s capital proceeds for granting the right are $250,000 even if the home is valued at $700,000. Mary’s assessable capital gain is $235,000 ($250,000 less $15,000). The main residence exemption and the 50 per cent CGT discount cannot reduce Mary’s taxable capital gain. Annie may claim the main residence exemption for the transfer of her home to Mary. If Annie passes away, her right to occupancy terminates with no CGT implications.

Other considerations 

CGT should be carefully considered when selling or transferring CGT assets to pay for a granny flat arrangement. The CGT exemption for main residence may fully or partially exempt capital gains on the home, however stamp duty may still be payable on the transfer of property.

The contract should reflect the expectations of both parties, their rights and obligations. It should provide for situations where the arrangement must come to an end including provisions for alternative accommodation or money that may be given back to the grantee.

Conclusion

The main advantage of informal granny flat arrangements is that there are no CGT implications for the grantor and there are many family situations where this is the right option. However as informal arrangements do not offer as much protection for the grantee and could result in challenges to their estate, it’s important advisers alert their clients to these issues. The prospect of a capital gains tax bill can deter parties from formal arrangements, however since 1 July 2021, this is no longer a concern for some elderly and disabled clients, where the foremost consideration should always be their protection.

Next: SMSF contributions