As the Australian population continues to age, there is expected to be greater pressure on all areas of society, particularly income support, health and aged care. With many retirees expected to reconsider their accommodation requirements, financial advisers are likely to be faced with greater demand for information on alternative living arrangements. Granny flats are a popular form of aged care accommodation, with a number of social and economic advantages. However, they also have a wide range of implications in terms of taxation and social security which make financial planning advice essential.
At present, over one million Australians receive some form of aged care and over 92% of all residential aged care places are occupied. Increased pressure on these facilities as the population ages will mean that by choice or necessity, many Australian’s will have to consider alternative forms of aged care accommodation.
Population under pressure
Like most developed countries, Australia has an ageing population. According to Access Economics, approximately 25% of all people are expected to be aged over 65 by 2051, with the number of people aged over 85 expected to quadruple.
These demographic changes will lead to increased pressure on many aspects of society, including income support, health and aged care. While some retirees may choose to sell the family home and downsize to a smaller dwelling to meet their changing accommodation needs, others may consider retirement villages or residential aged care facilities. At some point, most retirees will reach the stage where living arrangements have to be considered. At present, over one million Australians receive some form of aged care and over 92% of all residential aged care places are occupied. Increased pressure on these facilities as the population ages will mean that by choice or necessity, many Australian’s will have to consider alternative forms of aged care accommodation.
Granny flats are a popular alternative, particularly where family or friends are willing to help care for an elderly person. However, because granny flat arrangements have implications in terms of social security and taxation for both the retiree and the property owner, it is important that all aspects of the arrangement are considered.
What is a granny flat?
According to Centrelink, a granny flat is defined as ‘… a self-contained unit within or attached to another home, often with the intent that the resident will be close to family who can help if required’. (Centrelink, 2009). However, for the purposes of social security, Centrelink will also regard a home as a granny flat if:
- it is part of a private residence
- it is not owned by the person who lives there, their partner or an entity (such as a trust or company) that they control, or
- they have established a granny flat interest (Centrelink, 2009).
What is a granny flat interest?
As opposed to a granny flat, a granny flat interest is used to describe ‘when a person exchanges assets or money for a right to reside in someone else’s property for as long as they live'. (Centrelink, 2009)
Where a person:
- transfers the ownership of their home in exchange for a right to live there for their lifetime
- pays for the construction of the granny flat and obtains a lifetime right to live there, or
- purchases a property in someone else’s name and obtains a lifetime right to live there (Centrelink, 2009).
This is termed a ‘life interest’ or a ‘life tenancy’. A life tenancy allows a client to live in the property for the rest of their life, while a life interest gives them the right to use and benefit from the property as they wish. Provided the client is living in the property, both of these scenarios meet the Centrelink definition of a granny flat interest.
It is important to note that a granny flat interest exists only during a person’s lifetime and does not form part of their estate. A person cannot have a granny flat interest if they legally own the property.
In the case that the owner of the property wishes to sell, a granny flat interest cannot simply be terminated. The owner may:
- sell the property with the life tenancy or interest as a condition of sale
- transfer the life tenancy or interest to another property, or
- compensate the life tenant financially for losing their granny flat interest (Centrelink, 2009).
Why choose a granny flat?
Granny flats may include a number of advantages and disadvantages for both the retiree and the property owner.
On the positive side, a granny flat enables a retiree to maintain their independence while being close to friends and family who can provide care if necessary. When you think about retirement villages and aged care facilities it invokes thoughts of dependence. The granny flat provides a level of independence but still provides good social security support for the elderly. A granny flat interest can also offer increased security for the retiree with the social benefits of being closer to friends, family and grandchildren. For the homeowner this can be mutually beneficial as they can ensure their elderly parent is cared for, giving both parties peace of mind.
Financially, a granny flat arrangement can allow a retiree to make a transition into aged care accommodation without major disruptions to their finances. As a retiree may transfer the title of their home to establish the granny flat interest, this can also mean they can see the benefits of their children utilising their assets while gaining the benefits of aged care, rather than having them form part of their estate. Depending on how much is paid for the granny flat interest, retirees may still be able to access rent assistance, and the smaller size of the property often means that living costs such as energy bills and maintenance are lower.
However, one of the potential disadvantages of a granny flat interest can also be determined by financial circumstances. If Centrelink deems that the retiree paid too much for their granny flat interest, they might be ineligible to receive rent assistance, which could lead to an increased burden on their living costs. Property owners also need to consider the cost of modifying their own home and whether this can be recouped, as well as the potential capital gains tax (CGT) implications. In the case where a retiree transfers a property to establish a granny flat interest, the recipient of the property will become liable for CGT. By transferring a property and formally creating a granny flat interest, a person is ‘essentially converting something that was otherwise tax-free as a main residence should it be bequeathed in a Will, to something which is taxable upfront. This means that ‘you can actually create a tax liability for the party that’s creating that right to occupy’ and the recipient of the property needs to consider whether they can cope with this.
The Department of Family, Housing, Community Services and Indigenous Affairs say it is important for retirees to understand that their care requirements may increase and to budget for these accordingly. In choosing a new home, retirees will also have to consider its proximity to services such as transport, shops and healthcare as well as shared use of facilities with the property owners.
Granny flats: the importance of documentation
As granny flat arrangements are often held with family members, they are not necessarily formally documented. However, as with any arrangement where the transfer of assets is involved, the ongoing legal, taxation and social security implications make it important to gain an appropriate level of documentation. Centrelink don’t require a granny flat interest to be recorded in writing, but they do encourage those going into a granny flat interest to seek legal advice and get a solicitor to actually draw up an agreement. The reason being, as is the case in most situations, circumstances change and you need to ensure that you have put in place something in writing.
If a property were to be sold or the property owners divorce, a legal document outlining the value and tenure of a granny flat arrangement can help the retiree protect their granny flat interest. Granny flat arrangements can also be complex from a tax and legal perspective.
For example, if all I grant you is a mere right to occupy a premises, from a tax point of view you might sit back and say well I haven’t created a right as such, it’s just a family arrangement. However, from a legal perspective the lawyers would actually be sitting there and saying “well actually you’re not really protecting yourself. This highlights the importance of a document to underscore the arrangement. Granny flat arrangements can also have implications in terms of social security payments for the retiree and in this sense, it is important to document the amount paid for the granny flat interest. This can also help paint a clear picture of what each party is getting themselves into and help resolve any disputes quickly in future.
Valuing a granny flat interest
As the value of a granny flat interest has large implications in terms of tax and social security, an accurate assessment of this value is crucial. However, because granny flats and granny flat interests are often informal arrangements and not bought or sold on the market, it can be difficult to accurately assess their worth. To combat this, Centrelink employs a range of rules to establish the value of a granny flat interest. Generally speaking, when a granny flat interest is established, a person transfers cash or assets which may include their own home, to the property owner in exchange for the life tenancy or interest. Where this is the case, Centrelink regards the amount paid for the granny flat interest as the value of the asset. Where you are transferring the title of your home, where you are building the granny flat within someone’s property or you’re buying a property for that purpose. In those sorts of situations then it's just the amount paid and that’s it. However, where a client transfers additional assets, Centrelink will value a granny flat interest differently. In this case, a ‘reasonableness test’ is applied to determine whether the retiree paid too much for their granny flat interest and thus deprived themselves of assets, which can impact on social security payments.
The reasonableness test is used in circumstances where the value of the granny flat interest is different to the actual amount paid. A good example of this could be where someone is transferring title plus they are transferring additional assets. In that sort of situation, Centrelink will apply the test for reasonableness to see whether they are actually paying more than they should be for that granny flat interest. The ‘reasonable amount’ is found by multiplying the combined partnered rate of annual pension by an age-related factor.
Once this amount has been established, the value of the granny flat becomes the greater of this figure, compared with the actual amount paid. It is important to note that if the granny flat arrangement involves a couple, Centrelink will use the age of the younger partner and as of April 2010, the combined rate of the married pension was $26,338.(This changes each year).
Indira, aged 76, buys a property in her daughter Rachel’s name that is worth $280,000. She also gives Rachel assets worth $100,000 in return for a life interest in the property.
- Because Indira has transferred additional assets, Centrelink will use the reasonableness test to establish the value of the granny flat interest.
- The reasonable amount is the combined pension rate ($26,338) multiplied by the age conversion factor for age 76 (12.11) = $319,000.
- Because $319,000 is greater than the $280,000 cost of the property, $319,000 is the value of the granny flat interest.
- However, because Indira transferred a total of $380,000 to Rachel ($280,000 + $100,000), this is more than the reasonable amount and the excess amount is considered a ‘deprived asset’.
While a person can give away as much as they like at any time, amounts over $10,000 in one financial year and $30,000 in a rolling five-year period are treated as ‘deprived assets’ with implications for the amount of rent assistance a retiree can receive. The deprivation rules basically are an anti-avoidance mechanism that are established to protect the revenue from situations where someone may gift away their assets and give away assets in a situation where they can then satisfy the asset test and then be eligible for more pensions or other concessions. In Indira’s case above, the remaining value would be worked out as follows:
- $380,000 - $319,000 - $10,000 (gifting limit) = $51,000.
- $51,000 is considered a ‘deprived asset’ and is therefore subject to asset testing.
- This will impact on the amount of income support Indira receives.
In this sense, the deprivation rules work to prevent retirees from giving away their homes and continuing to benefit from rent assistance. The deprivation rules will also apply if the client fails to occupy the granny flat for a full five years following the creation of their granny flat interest.
The final step in Centrelink’s assessment of a granny flat interest is whether the client is regarded as a ‘homeowner’ or ‘non-homeowner’. This can determine:
- if the amount paid for the granny flat interest is considered an asset
- which asset test threshold applies
- whether the client is entitled to rent assistance.
To determine whether the retiree is regarded as a homeowner, the amount paid for the granny flat or ‘entry contribution’ is compared against the extra allowable amount (EAA).
This is regardless of whether the amount paid for the property is assessed under the reasonableness test or not and for the 2009/10 financial year the EAA amount is $129,000. If the entry contribution is less than $129,000, the person will be regarded as a non-homeowner. This means that rent assistance may be payable and the entry contribution is assessed as an asset but not deemed. If the entry contribution is more than $129,000, the person will be regarded as a homeowner, which means rent assistance is not available and the entry contribution is not assessed as an asset.
Rose is a non-home owner with $65,000 in assets. She arranged with her son David to pay for an extension to his home in exchange for a life tenancy. For Centrelink purposes, this would be considered a granny flat interest. Both parties consulted a solicitor and Rose contributed $45,000 cash to David for building her granny flat interest. She retained $25,000 in assets.
- Because Rose contributed only $45,000 and no additional assets, the reasonableness test need not apply. The value of the granny flat interest is $45,000.
- Rose paid less than $129,000 (the EAA) for her granny flat interest and is therefore classed as a non-home owner.
- The $45,000 contribution is assessed as Rose’s asset but not deemed.
- Rose’s total assessable assets are $65,000. Her age pension is not affected by the move under either the income or assets test, and she remains within the non-homeowner asset test limits.
- If Rose pays enough rent, she may be entitled to rent assistance.
- However, if Rose stops living in the granny flat within five years, Centrelink will review the granny flat interest and if the reason for leaving could have been anticipated at the time the granny flat interest was created, the deprivation rules will apply.
Capital gains tax and granny flat interests
As the creation of a granny flat interest usually involves some form of asset transfer, there are important implications in terms of CGT. CGT is a tax paid on any capital gain, when a CGT event occurs. This usually occurs with the buying or selling of property or shares and ‘net capital gains’ are the result of ‘total capital gains’ minus ‘total capital losses’ for the year. As CGT is a component of income tax, a person is taxed on their net capital gains at their marginal tax rate. Generally speaking, main assets such as a primary residence are exempt from CGT. This means that for the retiree, if they are to transfer the title of their main residence in exchange for a granny flat interest, they are not subject to CGT consequences.
They’ve disposed of their main residence and they’ve acquired an asset. So they don’t actually have any capital gains tax consequences in relation to the acquisition of that asset. However, for the property owner, the CGT consequences of obtaining a property could be substantial. Under Taxation Ruling TR 2006/14 Income tax: capital gains tax: consequences of creating life and remainder interests in property and of later events affecting those interests, where a lifetime right to reside in a property is granted, CGT event D1 occurs and this means that by creating a granny flat interest, the property owner is liable to pay CGT on the asset they have acquired, once the cost of creating the granny flat interest has been deducted.
It’s not something which you’d sit back and say “okay let’s just transfer a $500,000 property”, because ‘you’re going to have somewhere between $200,000–$230,000 worth of tax payable in creating them a right to occupy. Yet while the transfer of an asset can create a tax liability in the short term, there can be benefits for the property owner in the long term. Whilst they might get a tax liability in relation to the granting of the right to occupy; if it’s used for income producing purposes in the future, then maybe that’s an opportunity to claw back some of that tax cost that you’ve otherwise foregone.
Overall, the complexity of the taxation implications of asset transfer means it is essential to consult tax experts when it comes to creating a granny flat interest.
Tips for financial advisers
As the Australian population continues to age, financial advisers are likely to be faced with an increasing demand for advice on aged care accommodation. Yet, due to the complex and specific intersection of legal, tax and social security elements, it is important that financial advisers gain a sound understanding of how best to advise their clients when it comes to granny flat arrangements. In the first instance, an understanding of their client’s needs and financial situation is important. From a financial planning point of view, the best thing to do would be to look at whether the client or the potential granny flat occupant would be best off within a granny flat situation. In evaluating the advantages and disadvantages of creating a granny flat interest, this could provide both the homeowner and the retiree with a view of how best to proceed. Once this has been done, gaining the right advice is crucial. Speaking to the right people. You’ve got to speak to the lawyers, you’ve got to speak to the tax advisers, you’ve got to speak to the financial advisers. All these guys need to be talking together- it would be beneficial to get them in the same room just to ensure that everyone is on that same page. This will help to make everyone involved aware of all the issues and what the arrangement will mean for them in future.
As the creation of a granny flat interest also has widespread implications in terms of social security, it is essential for the retiree to consider how their rent assistance and assets will be affected by obtaining a life interest in a property. In this sense, the creation of a legal document will help anchor the granny flat arrangement, providing legal security for both parties involved. Formal documentation will also help outline the potential CGT implications of creating a contractual right, ensuring that the property owner knows what is coming their way and that they have the cash flow to cope with gaining a substantial tax liability. Another important factor for property owners and retirees to consider is the legal implications of transferring an asset. Essentially, the creation of a granny flat means that the retiree has, shifted the timing of the movement of the asset from being dealt with at death to being dealt with up front and this gives family members access to the asset which would otherwise have been dealt with under the Will.
Finally, to minimise the impact of unforeseen events, prevention is always the best cure. The creation of granny flat interests can be a minefield and the legal and the tax implications don’t always meet in the middle. In this case, the best thing that can be done is to seek legal and professional advice, because ‘it’s always easier to deal with it beforehand than it is to deal with it afterwards.
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