One question investors often ask about claiming depreciation on a rental property is ‘how will these claims affect Capital Gains Tax (CGT) when the property is sold?’
CGT can be a complex topic for investors to understand, particularly as the answer to the above question can really depend on the scenario of the individual property investor.
Introduced on the 20th of September 1985, CGT is basically the tax payable on the difference between what it cost you to purchase an asset and the amount you received when you disposed of it.
When you sell a property, this triggers what is called a ‘CGT event’ and the owner will either make a capital gain or loss on the property.
To calculate your capital gain or loss, use the following method:
To help explain the implications of property depreciation on CGT, here are six facts investors should be aware of:
1. What is property depreciation?
Property depreciation is the wear and tear of a building and the plant and equipment items within it*.
The Australian Taxation Office (ATO) allows owners of income producing properties to claim this depreciation as a deduction in their annual tax return, meaning they pay less tax.
Property depreciation is made up of two main parts: capital works deductions and plant and equipment depreciation.
2. How do capital works deductions affect CGT?
Capital works deductions are available for the wear and tear on the structure of the building.
Examples of items which can be claimed include bricks, walls, floors, roofs, windows, tiles and electrical cabling.
The capital works deductions will reduce the cost base of the property, which will add to the capital gain and therefore increase the amount of CGT applicable for the owner of the property.
3. How does plant and equipment depreciation affect CGT?
Depreciation deductions can be claimed for the mechanical and easily removable plant and equipment assets contained within an investment property*.
When a property is sold, a gain or loss is calculated separately on these items.
As outlined by the ATO on their website, you can make a capital gain if the termination value of your depreciating asset is greater than its cost.
You make a capital loss if the reverse is the case.
That is, the asset’s cost is more than the termination value.
* Under new legislation outlined in the Treasury Laws Amendment (Housing Tax Integrity) Bill 2017 passed by Parliament on 15th November 2017, investors who exchange contracts on a second-hand residential property after 7:30pm on 9th May 2017 will no longer be able to claim depreciation on previously used plant and equipment assets. Investors can claim deductions on plant and equipment assets they purchase and directly incur the expense for. Investors who purchased prior to this date and those who purchase a brand new property will still be able to claim depreciation as they were previously. To learn more visit www.bmtqs.com.au/budget-2017 or read BMT’s comprehensive White Paper document at www.bmtqs.com.au/2017-budget-whitepaper
4. Have the recent changes to depreciation legislation had any effect on CGT?
The amended legislation following the 9 May 2017 Budget outlines some detail around a reduced CGT liability for property investors.
There are scenarios where the values of plant and equipment will be needed.
This includes when an asset is scrapped, where there is a partial or full CGT exemption and where the exchange date and settlement date on the sale of the property occur in separate financial years.
The BMT Capital Allowance and Tax Depreciation Schedule includes the capital loss values on plant and equipment to allow the offset against any future capital gains, should a property investor dispose of the assets.
We recommend that investors speak with an Accountant or Tax Adviser when completing this process.
Depending on the circumstances, a property investor who is unable to claim depreciation on previously used plant and equipment assets due to these amendments should be able to claim a capital loss for the decline in value of the plant and equipment assets.
This capital loss should only be able to offset a capital gain and if needed can be carried forward to offset future capital gains.
5. What CGT exemptions apply for a principal place of residence?
Properties which are owned by someone who resides, occupies or lives in the property as their home are exempt from CGT so long as the dwelling is used mainly for residential accommodation and is located on land under two hectares in size.
If the owner of a primary place of residence chooses to move out of their home and rent it out, a CGT exemption is available for up to six years after they have moved out so long as they don’t own another primary place of residence.
If the owner moves back into their investment property, then moves out and rents the property again, a new six year period will commence from the time they last moved out of the property.
There is currently no limit to the number of times a property owner can do this so long as each absence is less than six years.
Only one property can be classed as a primary place of residence and therefore exempt from CGT at any one time with the exception of the following rules.
These rules apply if both properties are treated as the owner’s primary place of residence within a six month period:
- The old property was the owner’s primary place of residence for a continuous period of at least three months in the twelve months before they sold it
- An owner did not use the property to provide an assessable income in any part of the twelve months when it was not their primary place of residence
- The new property becomes the property owner’s primary place of residence
6. Are property investors eligible for a discount?
A 50 per cent exemption on CGT is available to individuals or small business owners who hold an investment property for more than twelve months from the signing date of the contract before selling the property.
7. Is it still worthwhile claiming property depreciation if it will later add to the capital gain?
The short answer is yes. During the term of ownership, capital works and plant and equipment can be claimed as a deduction at the investor’s marginal tax rate.
These deductions will reduce tax liabilities, therefore generating additional cash flow for the investor each year.
When a property is sold, if the owner has held the property in their name for more than twelve months, the owner will be eligible for the 50 per cent exemption.
This means that only 50 per cent of the capital works deductions during ownership will carry through to the ‘CGT event’, making it far better for a property investor to claim the capital works deductions and take advantage of the additional cash flow during ownership.
Depreciation claims also provide an opportunity for the property owner to invest further or reduce loan liabilities.
When considering selling an investment property, it is recommended that investors seek advice from their Accountant about the implications of CGT and the exemptions available.
A specialist Quantity Surveyor can also provide advice on the depreciation deductions for any investment property.
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