Renting out part of your home could trigger a capital gains tax bill

One of the great advantages of owning your own home in Australia is that any increase in value is generally exempt from capital gains tax while the property qualifies as your main residence.

For many homeowners this means they give little thought to CGT. They live in the property, pay the mortgage, council rates, insurance and maintenance costs and eventually expect to sell without paying tax on the gain.

That can change when you start making money from part of the property.

Two increasingly common examples are converting an unused part of the existing home into separate accommodation through Airbnb or building a secondary dwelling or granny flat and renting it to a tenant.

Both can be particularly good uses of a property you already own. They can generate significant additional income without having to buy another block of land or another investment property and, in the case of a secondary dwelling, can also contribute to providing more affordable housing.

However, both can create a future CGT liability on part of what was previously a completely tax-free family home. That does not necessarily make either strategy unattractive, but it does mean you should understand what you are creating before you start.

We have already seen what keeping records can be worth

I previously wrote in API Magazine about a family who reduced their capital gains tax bill by almost $14,000 because they had retained records of approximately $75,000 of costs associated with owning their property.

The benefit came from expenditure incurred many years earlier and, importantly, having the records available when they eventually needed them.

When we move to your own main residence, keeping records is just as important, but there is a twist. If the rule below applies, most of what you spent on the home before it started producing income generally stops counting for CGT. The records that matter are the ones you keep from the change onwards.

When your home starts producing income

Where a home has been your main residence and was fully covered by the main residence exemption before it is first used to produce income, a special CGT rule can apply.

Broadly, where the rule applies you are treated as having acquired the property at its market value when it first starts producing income. It is not something you choose. If the conditions are met, that value becomes your starting point.

That means if you bought your home for $500,000 ten years ago and it is worth around $1 million when you first start renting part of it, the original $500,000 purchase price, and the costs you incurred along the way, are not necessarily where the later CGT calculation starts. The value when the income-producing use commences can become extremely important.

This is one of the reasons I would consider obtaining an appropriate market valuation when the use changes rather than trying to establish what the property was worth 10 or 15 years later when it is eventually sold.

Let us look at two practical examples.

Example one: converting part of the home for Airbnb

Assume John and Sarah bought their family home 10 years ago and have lived in it as their main residence for the entire period.

They have an attached garage that is no longer needed for cars. The area has suitable access and can be separated from the main living areas of the house. They spend approximately $30,000 turning it into a self-contained studio with its own bathroom and small kitchenette.

Once completed they list the studio for short-term accommodation.

At that time, the entire property is independently valued at $1.03 million. The studio represents approximately 15 per cent of the total floor area of the home.

Assume they charge an average of $200 per night and achieve 50 per cent occupancy. That produces approximately $36,500 of gross income each year while John and Sarah continue living in the remaining 85 per cent of the property.

Ten years later they sell the entire property for $1.5 million.

Ignoring additional cost-base expenditure and any capital works deductions for the moment, the increase in value from the $1.03 million starting value is $470,000.

If 15 per cent is reasonably attributable to the part used to produce income, the potentially taxable component of the gain is approximately $70,500.

Under the current rules, the 50 per cent CGT discount would apply to the whole gain, reducing this to $35,250 being included in assessable income. I will come back to how the Budget changes affect this shortly.

If we use an effective marginal tax rate of 39 per cent, including Medicare levy, purely for this example, the resulting tax is approximately $13,750.

That figure can initially look like a fairly significant consequence of renting out part of the family home. But over the same 10 years the studio has potentially produced around $365,000 of gross accommodation income before allowing for any increase in nightly rates.

The CGT needs to be considered, but it should not be looked at in isolation.

There is another issue with short-term accommodation. If a dedicated area is genuinely available for rent throughout the year, the CGT exposure is not necessarily determined simply by counting the nights somebody actually stays there. The period for which that part of the property is used or available for income-producing purposes can also become relevant.

This is why records showing when the accommodation first became available and any periods when it was removed from the rental market can be important.

Example two: building a two-bedroom granny flat

Now consider David and Lisa.

They have also lived in their home for 10 years and the property has been their main residence throughout.

Their block is large enough to build a proper two-bedroom secondary dwelling. They spend $200,000 constructing it and once completed, rent it to an unrelated tenant for $600 per week.

When the granny flat is completed and first becomes available for rent, the entire property is valued at $1.2 million.

For this simplified example, assume the secondary dwelling and the area reasonably associated with it represent 25 per cent of the overall property for CGT purposes. A granny flat is a separate dwelling rather than a room in the house, so working out the right split in practice needs specific advice. The 25 per cent is purely illustrative.

The rental income is $31,200 per year. Over 10 years that represents $312,000 of gross rent before allowing for any future rent increases.

David and Lisa continue living in the main residence and 10 years later the entire property is sold for $1.8 million.

The increase from the $1.2 million value when the income-producing use commenced is $600,000.

If 25 per cent is reasonably attributable to the income-producing portion, the potentially taxable component of the gain is $150,000.

Applying the 50 per cent CGT discount on the same current-rules basis, $75,000 would be included in assessable income.

At the same illustrative effective tax rate of 39 per cent, the tax would be approximately $29,250.

Again, that number by itself can look significant. But the granny flat has also generated at least $312,000 of gross rent over the same period before allowing for rental increases and the owners still have a substantial additional dwelling sitting on the property.

Whether the strategy was worthwhile cannot be determined simply by looking at the $29,250 CGT liability.

The Budget changes will move these numbers

Both examples apply the 50 per cent discount to the whole gain, which is how the rules work today. That is changing. The 2026-27 Federal Budget announced that the discount would be replaced with CPI indexation of the cost base and a 30 per cent minimum tax on capital gains from 1 July 2027. The core legislation passed in June 2026, although some of the detail is still in draft.

Your main residence exemption is not affected. The taxable share of the gain on the rented part of the property is. For property held before 1 July 2027, the gain up to that date keeps the 50 per cent discount and the gain after it falls under the new rules, using the property's market value at that date as the new starting point. The Budget night grandfathering applies to negative gearing, not to the CGT discount.

On a sale 10 years from now, most of the gain in both examples falls under the new system, so the tax could look quite different from the figures above. How the market value rule for homes first used to produce income will interact with the 1 July 2027 valuation also still has to be worked through in practice. Treat the CGT figures here as an illustration of the current rules rather than a forecast. It is also one more reason to have a valuation on file.

Start keeping records when the use changes

Once part of a family home begins producing income, I would treat that change seriously from a recordkeeping perspective.

The market value at the time the income-producing use commences can become particularly important where the home-first-used-to-produce-income rule applies. If you hold the property on 1 July 2027, its value at that date will matter as well.

For the CGT side, I would keep those valuations along with plans and measurements showing which part of the property is being rented, construction or conversion invoices, records of any capital works deductions claimed and evidence of when the accommodation first became available.

For the income tax side, keep the loan documentation, council rates, insurance and repair records. The share of those costs that relates to the rented area is generally deductible against the rent each year.

Some expenses may be deductible against the rental income each year. Others may potentially have relevance to the future CGT cost base.

You cannot generally claim the same expense as an income tax deduction and then claim it again through the CGT cost base. Capital works deductions also reduce the cost base, which increases the eventual gain. The treatment needs to be considered properly.

What matters at the time is keeping the information. Your accountant can determine what is relevant when the property is eventually sold. They cannot reconstruct records that disappeared 15 years earlier.

Creating CGT is not necessarily a bad outcome

There is a tendency to assume that losing part of the main residence CGT exemption should always be avoided. I do not think that is the right way to assess it.

If spending $30,000 converting an unused area of your home can create tens of thousands of dollars of additional annual income, accepting some future CGT may be a reasonable trade-off. The same can apply to spending $200,000 on a secondary dwelling if the rental income and longer-term value justify the additional capital.

The real question is not whether CGT will apply. It is whether the financial benefit of the strategy outweighs the cost of creating it, the ongoing expenses and the eventual tax.

In the next article I will take these same examples and examine that question in more detail. Once the capital required, running costs, income generated and estimated CGT are considered together, the option that produces the highest rent may not necessarily produce the best overall outcome.