Adding a granny flat to a property is becoming an increasingly popular option among homeowners and investors alike.

While a range of granny flat scenarios and arrangements can provide additional living space and potential rental-income, consideration must be given to the various tax implications and financial ramifications before adding such a building to your property.

Under the main residence exemption,  homeowners don’t pay capital gains tax (CGT) upon selling the home they live in. However, those who use any part of their property to produce income – for example, renting out a granny flat  – are generally not entitled to the full exemption.

Granny flats cannot be included in a separate ownership title. Instead, the cost of the granny flat is added to the price of the property and, therefore, cannot be sold separately.

CGT applies to the granny flat portion of the property and is calculated by how many years it has been in existence. For example, if you have owned the property for 10 years, but the flat was built five years ago, you do not need to pay CGT on the first five years.

If the granny flat is rented out at normal commercial rates, all rental income received will be taxable, and deductions can be claimed for expenses incurred such as insurance and utilities, as well as depreciation of furniture and fittings.

For those in the business of building and commercially letting out granny flats any gains would be first assessed as ordinary income or  profit and a partial CGT exemption would apply  on any subsequent disposal of the property on the basis of income use.

Where the granny flat is occupied by relatives or adult children and no commercial rent is charged, the whole property will qualify for the CGT main residence exemption – resulting in no CGT payable.

Note that payments from a family member  for board or lodging are considered to be domestic arrangements and are not rental income. In these situations, you cannot claim income tax deductions.

For granny flats on subdivided land, the CGT main residence exemption will not apply on the eventual disposal of the property, as it is only exempt when sold with the home that is your main residence.