Depreciation is generally well understood in a general context, especially for working business assets.
But what about for property?
We explore types of property depreciation, when to prepare a depreciation schedule and common depreciation traps.
What is depreciation?
By definition, depreciation is the natural wear and tear of property and assets over time. After interest expenses, it is the second-largest tax deduction available for investment property owners.
For depreciation on investment property, the Australian Taxation Office (ATO) will allow you to claim depreciation for the forecasted loss of the building value as it ages and approaches the end of its useful life.
Old and New Buildings – the difference
Depreciation on new properties is spread over 40 years. On a new building that costs $200,000 to build, you could make a $5,000 tax claim each year for 40 years (i.e. 2.5% per year) as a simple example.
For a property built after 15 September 1987, you’d be able to claim 2.5% depreciation each year until it was 40 years old. Therefore, on a property built for $100,000 in 1990, you could claim a $2,500 depreciation deduction each year until 2030.
We typically associate depreciation with new property. However, if you purchase an existing property, structural costs can be depreciated, but the plant and equipment generally can’t, as it is purchased as “second-hand”.
Different rules apply for properties acquired after 9 May 2017 as depreciation only applies for costs on plant and equipment you paid for (e.g. new carpets or fridge); or plant and equipment included as part of the new property (see below).
Types of Property Depreciation
Depreciation deductions are divided into two distinct categories:
Capital Works
Capital works cover the roof, walls, doors, kitchens, bathroom fittings, for example. Depreciation relates to claims for the ageing that occur in the property’s structure or expenses incurred in building the property. It also applies to structural improvements, such as alterations made to the property.
Plant & Equipment
This type of depreciation is more granular and diverse and applies to easily removable fixtures, and fittings found within the property. Items like carpet, air conditioners, curtains, water systems, smoke detectors, etc., can be claimed. The ATO assigns varying individual effective life and depreciation rates for these different classes.
Benefits of Property Depreciation
Firstly, and perhaps obviously, investors can claim tax deductions against the rental income from property, which will add to the overall gearing position.
Division 43 of the Tax Act also provides a system of deducting capital expenditure incurred in the construction of buildings and other capital works used to produce assessable income. Often, a Quantity Surveyor will need to estimate anything in the property that is part of a previous renovation and make adjustments.
Common Property Depreciation Traps
Not getting a tax depreciation schedule prepared
Substantial deductions may be available for structural or plant and equipment assets that are not correctly identified and claimed. A depreciation report starts from the date you settled on the property, not when you engage a surveyor. Therefore the best time to get a report prepared is as close to settlement as possible, although an accountant can amend tax returns to backdate a depreciation schedule by up to two years if required.
Not reviewing your depreciation schedule
Since the schedule is generally valid for the life of the building, it is often a “set and forget” strategy. However, a review is recommended if renovations or repairs occur or if plant and equipment are replaced.
Selecting the wrong depreciation formula
The Prime Cost method provides a tax deduction each year over the item’s effective life. In comparison, the Diminishing Value method gives a higher claim in the first years of the item’s effective life, and smaller claims later on. Seek advice from your accountant as to which option is best for your circumstance.
Buying the wrong asset for larger deductions
More depreciation may contribute to a net rental loss - negative gearing. Many people get blinded by the appeal of tax deductions and end up owning a property that performs poorly in the long term. Remember, a loss is a loss, even if depreciation benefits could soften it.
Getting it back on the Sale
The depreciation previously claimed over the years is added back to the cost base used to calculate capital gains tax when you sell the property. The result being you may have a bigger tax bill than expected on sale.
Always seek accounting and legal advice specific to your circumstances. For those interested in assessing depreciation offsets, the ATO depreciation calculator can be found here https://www.ato.gov.au/calculators-and-tools/depreciation-and-capital-allowances-tool/
More information?
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The team at MCP Financial Services has specialised expertise in supporting your property journey.