Due to rising house prices, the humble granny flat has become a popular investment property strategy for homeowners and investors seeking to maximise returns on existing properties.

However, there are Capital Gains Tax (CGT) implications associated with such arrangements.

In a basic scenario where the granny flat is occupied by a family member on a noncommercial basis and the home is sold, a full CGT main residence exemption is still available. While the flat is used for private purposes, the exemption extends to adjacent land of up to two hectares from the main dwelling.

A partial main residence exemption will apply when the granny flat is leased at commercial rates. The CGT liability for the portion of the property that is used for renting the granny flat is calculated on an area and time basis. The CGT 50 per cent discount will still be available when the home is owned for more than 12 months after to the time of the first income use.

Any non-deductible mortgage interest attributable to the land may be included in the cost of the land for CGT purposes, including subdivision costs reducing capital gains tax liability.

In a situation where the backyard has been subdivided and sold, CGT provisions prevents the CGT main residence exemption.

However, the circumstances change for those in the business of constructing and leasing or selling granny flats. Gains are determined as normal income or profit, instead of under the CGT regime.
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