Tax Issues of Building ‘Granny Flat’

<i> Kass is a Washington lawyer and newspaper columnist specializing in real estate and tax matters</i>

QUESTION: We are in our 60s and are contemplating selling our large home and adding a “granny flat” of 1,000 square feet to a home owned by our son and his wife. They are amenable.

We would finance the construction because the equity in our present home would be more than enough to cover the cost. What is the best way to proceed to protect everyone’s interest, and what should be covered in the agreement our attorney will draw up?

ANSWER: First, the tax issues. On the assumption that you and your wife have been living in your house for three out of the past five years, because you are in your 60s, you are eligible for the once-in-a-lifetime exemption of up to $125,000 of any profits you earned on your house.

However, if you have made a profit of more than $125,000, this additional gain will be taxed at ordinary income tax rates. It is possible that this additional gain will kick you into the highest tax bracket, which currently for married individuals filing joint returns can be as high as 33% on any taxable income between $74,850 and $155,320.


If the profit is significant, you might want to consider hanging on to the house, renting it out, and leaving it as an inheritance for your children.

They would then obtain the “stepped-up” basis which currently under tax laws would save them from having to pay the tax on the profit that you may have to pay.

The partnership issue is also complex.

The last thing you want is to have your other children fighting and bickering over the ownership of that addition. It must be kept in mind that you have taken perhaps your largest asset--i.e., your house--and in effect have given it to your son. While this may be your intention, there is an old expression that “when there is a will, there are relatives.”