I cannot tell you whether to go ahead with the development or not. What I can do is advise you as to the tax implications of building and selling a bungalow in your garden. Do you want me to go ahead?
Leave this with me while I draft my answer. It will take a while so please bear with me.
Assuming that the size of the plot of land that you own including the footprint of the property you live in is no more than half a hectare in size, you could sell the land required for the new bungalow to a developer and pay no taxes whatsoever.
If you develop a piece of your front garden yourself and sell the new property, you will almost certainly be treated as trading by HMRC and any profit you make will be subject to income tax. No National insurance contributions would be payable as you are over retirement age. On the face of it, you will make a profit of £100,000 (£170,000 - £70,000). However, you would need to allocate a proportion of the original purchase price of the whole property to the development so your ultimate profit would be lower than £100,000 and that is what you would pay income tax on. You would need to get specialist advice to determine the proportion of the original purchase price to be treated as the cost of the land on which the new bungalow would be built.
You say that neither of you pay tax. Disregarding any unused personal allowances, if you divided the profit by two, the first £32,000 for each of you would be taxable at 20% and anything left would be taxed at 40% for each of you if you were treated as a property development partnership by HMRC..
If you moved into the bungalow for a year or so and then sold it, you might escape tax altogether under the main residence exemption rules but HMRC would probably take a close look and seek to tax the gain if they thought you had moved into the property temporarily simply to try to avoid having to pay tax when you sold it. They may charge the gain to Capital Gains Tax as opposed to Income Tax. The first £11,100 of gains made by an individual in any one tax year are tax free. There are two rates of CGT for property gains, 18% and 28%. The rate or combination of rates that you would pay would be dependent on the the sum of your income and the gain in the tax year you dispose of the bungalow.
I hope this helps but let me know if you have any further questions.
You take the cost of the property 33 years ago and divide that between the land allocated to the new build and the rest of the site.
There is no inflation allowance I'm afraid.
There used to be allowances for inflation but they were withdrawn in lieu of lower rates of CGT.
If you move into the bungalow and make it your home then you might be able to sell it after a year or so and certainly if you sell the existing home first. If you do sell the existing home first, your bungalow will become your main home by default and any gain should be tax free.