Investment property depreciation is a popular tax break (or tax loophole as some like to call it) legally available to property investors.
Anyone who purchases a property for income-producing purposes is entitled to depreciate the building and the items within it against their tax-assessable income.
Not only will claiming a tax deduction against a depreciating property save you money at the end of the financial year, but it can even be the difference between a negatively geared investment property and one that delivers you positive cash flow.
After all, every property investor wants to pay the least amount of tax they legally need to, while increasing their income stream at the same time.
So here’s everything that property investors in Australia need to know about how to claim depreciation on an investment property, including how it works, what can be included, and the best calculations to use.
Depreciation on your investment property is a tax deduction tied to the aging and gradual wearing out of your real estate asset.
In simple terms, you might be eligible for tax deductions as your property ages.
But it’s a little more complicated than that.
When you invest in a property, the tax authorities don't see it as merely buying a building.
Instead, you're essentially acquiring land (which usually appreciates) as well as a physical structure along with a variety of additional assets (often referred to as plant items) that depreciate over time.
In terms of property investment, depreciation serves as a tax deduction that comes from two distinct areas the capital expenditures on the building itself and the depreciation of items (plant) within the property.
Capital expenditures can encompass things like building extensions, renovations, or improvements.
On the other hand, property contents generally include items that are not structurally integrated into the building, like appliances, carpets, air conditioners, heaters, and kitchen appliances.
So, over time you can write off the wear and tear of your income-producing assets.
But here’s a little wrinkle: while investment property depreciation is “officially” the amount that a property loses in value as it ages, that is not always the case in real life, because even though you write off the value of the physical building over a period of 40 years, it costs a lot more to build the same dwelling today than it did even five years ago, so the value of your asset may not have really depreciated at all.
But don't let this confuse you, so let's move on.
Instead think of it as money lost through wear and tear, which Australian law then says property investors can then offset as a tax dedication against their income.
When you buy an investment property in Australia, the ATO breaks it into two segments for depreciation:
- the building itself and
- any fixed items and the removable fixtures and fittings inside the property (called the ‘plant’).
This means there are two ways to calculate depreciation on investment property:
1. Capital works
This is the cost of building the investment property (i.e. the construction cost) and also includes the building structure such as the walls and the roof, but also fixed fixtures such as the bathroom sink, doors, or taps.
The depreciation of these is then spread over 40 years, which is the average length of time that the ATO expects a building to last.
2. Plant and equipment depreciation
This refers to the removable fixtures and fittings inside the property, such as any appliances, carpets, blinds, or curtains.
The ATO has a list of around 6,000 items and each item has its own 'effective life', or claimable period (which is usually a number of years).
The ATO requires, therefore, that investors separate their investment property depreciation values into the above two categories, working out what parts of the property or fixtures are removable and aren’t, and therefore what category they fit into.
Only properties built after July 1985 qualify for both types of deductions, but property investors can still claim plant and equipment depreciation on properties built before this date.
This means property investors should engage a quantity surveyor to calculate the total values for each category to work out the amount of depreciating property, and to do this they will prepare a depreciation schedule outlining the rate at which the assets decline in value and therefore the deductions that can be claimed.
A couple of years ago MCG Quantity Surveyors did a detailed investigation and ran some interesting numbers.
They divided houses and units into 10 categories that helped define their position in the tax depreciation race and then calculated the average first-year depreciation allowance across each of the property categories.
Here’s what MCG QS found:
|First Year Deductions
|2010- Current but not brand new
|2010-Current but not brand new
As you can see from the numbers, not surprisingly a brand-new property offers the most potential for a large depreciation allowance.
But what might surprise you is that the difference between a new house and a new unit or apartment is minimal.
But let’s be clear…don’t an investment property just for tax benefits like depreciation.
I’ve written a detailed article on this here: What makes a better investment – brand new or established properties?
While brand-new properties may offer high tax deductions and attract investors looking for cash flow, in general, this comes at the expense of capital growth and rental growth which is really what most property investors should be looking for.
And avoid off-the-plan properties, even though they are often sold on the basis of great depreciation allowances.
Because of all the uncertainty of buying off the plan, you should be paying a discount on today’s market price, but in general, you’re paying a premium.
This means buyers must have a solid cash reserve to protect them against a potential 'negative equity scenario'.
You may be wondering “How does a tax depreciation schedule work?”
Tax depreciation and the application of regulator guidelines is a tricky business and, unfortunately, less scrupulous operators in the marketeering space have been known to bamboozle naïve investors.
So it always pays to get the advice and help of an expert in the field to work out exactly what you can claim and how.
But, to help, here is a breakdown of the two ways that property investors could calculate tax depreciation on investment property.
1. Diminishing value
The diminishing value calculation for investment property depreciation is a simple method that gives higher claims at the beginning of the depreciating asset’s ‘effective life’ which then gets smaller as time goes on.
It’s a popular method for property investors which assumes that the asset depreciates quicker in the early years, and therefore investors are able to claim more earlier on in the investment.
The formula to calculate the diminishing value is as follows:
Base value x (days held ÷ 365) × (200% ÷ asset’s effective life)
Here’s an example of it in action:
A property investor purchases a security system for $2,500 including installation on the 1st of July.
According to the ATO, a security system has an ‘effective life’ of 5 years.
$2,500 x (365÷365) x 40% means the property investor can claim the following depreciation using this method:
Year 1: $2,500 x 40% = $1,000 is claimable
Year 2: $1,500 x 40% = $600 is claimable
Year 3: $900 x 40% = $360 is claimable
Year 4: $540 x 40% = $216 is claimable
Year 5: $324 x 40% = $129.60 is claimable
2. Prime cost
The prime cost calculation for investment property depreciation is an even simpler calculator which gives you the same value for tax deduction over the whole of the asset’s ‘effective life’.
Unlike the diminishing value calculation, the prime cost method assumes that the asset depreciates at the same rate over the entire applicable period, giving a more consistent tax depreciation.
The formula to calculate the prime cost is as follows:
Asset’s cost × (days held ÷ 365) × (100% ÷ asset’s effective life)
Here’s an example of it in action:
Using the same example as above, A property investor purchases a security system for $2,500 including installation on the 1st of July.
According to the ATO, a security system has an ‘effective life’ of 5 years.
$2,500 x (365÷365) x 20% means the property investor can claim the following depreciation using this method:
Year 1: $2,500 x 20% = $500
Year 2: $2,500 x 20% = $500
Year 3: $2,500 x 20% = $500
Year 4: $2,500 x 20% = $500
Year 5: $2,500 x 20% = $500
You’ll see that although for the first two years, a property investor is able to claim a smaller tax deduction for depreciation, by year 3 they can claim higher than using the other method.
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Many property investors don't realize that if you claim tax benefits for your property wearing down (called "depreciation"), it can affect the tax you pay when you sell that property for a profit.
Here's how it works:
- Let's say you sell a property and make $100,000 in profit.
- Over two years, you claimed $10,000 in depreciation on your tax returns.
- The Australian Tax Office (ATO) looks at it as if you made a $110,000 profit, not just $100,000.
Now you might think, "Why bother claiming depreciation if it's going to increase my taxes when I sell?" Good question.
There are several reasons:
If you've owned the property for more than a year, you only pay tax on half of the capital gain profit.
So, if you claimed $10,000 in depreciation, it's not a full $10,000 you'll owe in tax, it’s halved.
High Tax Bracket? No Worries
- Capital gains tax (CGT) impacts your overall taxable income.
- If you're in a high tax bracket, like 45%, the effect is reduced, so, you won't feel the pinch as much.
Money Loses Value Over Time
- Most people hold onto property for 10-14 years or more.
- Money's worth less in the future because of inflation.
- So, claiming $10,000 now and paying some of it back in taxes many years later is still a win for you.
Boost Your Cash Flow Early On
- When you first buy a property, you're usually focused on growing your investment.
- Claiming depreciation helps cover your costs like interest payments and upkeep.
- As years go by, you'll pay off more of your mortgage and possibly earn more in rent, so, it gets easier to cover your costs, and you might even start making extra money.
So, claiming depreciation can still put you ahead in the long run, despite some tax to pay later.
Note: When it comes to your investment property, a comprehensive depreciation schedule from a quantity surveyor will unearth plenty of opportunities to recoup some of those dollars come tax time.
And while the numbers can be compelling, it’s important to make an investment decision based purely on depreciation outcomes and its advantage.
That would be foolish.
There are many more, and several more important, considerations that need to be taken into account when building an investment portfolio.
For example, your income, goals, age of retirement, changes in family status – all will play a huge part in how you, as an investor, grow your cache of real estate holdings.
And almost all will be more crucial to property selection than the level of depreciation you can achieve.