The Property Investors ‘little gem’.
Depreciation is a hidden ‘gem’. Many property investors often overlook or don’t understand or appreciate, how depreciation puts money back into their pocket and how it impacts on their ability to hold and grow their property Investments. In this short article I want to demonstrate to you the impact that depreciation on a residential building has on your cash flow. This is a very simplistic example however it will demonstrate the power of this little ‘gem’ called, deprecation.
Firstly what is depreciation? It is a non-cash expense that reduces the value of an asset over time. When it’s stated that depreciation is “non-cash tax deduction ,” it means that depreciation is taken as an accounting entry tax deduction only and you don’t have to physically pay for it…pretty good eh? Property assets that can be depreciated include buildings, and improvements to buildings, leasehold improvements, furniture and fittings and many other items. However for this exercise, I am just going to focus on residential building depreciation bearing in mind that if you’re a property investor there are many other items that you can depreciate which would make the equation that much better for you.
As at June 2012, depreciation on the original costs of construction of a building can be claimed on any residential property built after July 17, 1985. In general this is at a rate of 2.5 per cent of the original construction cost each year for up to 40 years. But there are exceptions so it’s best to check with your accountant, or the Australian Taxation Office for finer detail.
It also might be possible to claim the costs of additional constructions on established properties – such as extensions, the addition or removal of an internal wall, or the construction of a carport, these can be claimed as capital work deductions. But there are some exceptions to be aware of;
- You can’t claim a tax deduction for alterations that have not yet been completed, even if costs have already been incurred.
- If you did the work yourself as an owner-builder, you cannot claim for the cost of your labour or any notional profit margin.
- You can only claim for the period of the year when the property was either rented or available for rent. Investment property owners have to be able to show they are actively seeking a tenant – for example, by appointing a real estate agent and advertising the property for lease.
Let’s take a look at a very basic example to show you the impact of buying a newer property which you can depreciate, vs an older property that does not have the ability to depreciate. We will make a couple of assumptions for this example….let us assume the purchase price of the new property is $500,000 ( building $250,000, land $250,000) and the old property is $500,000 ( no depreciation, as built pre July 17, 1985 ) and assume that we are on the top marginal tax rate of 47c.
Building Depreciation @ 2.5% of $250,000 = $6,250 (assuming owned for 12 months)
Assume tax rate of 47% @ $6,250 = $2,938 tax saved
Lifetime of Investment 40 Years x $2,938 = $117,500 potential tax saved
The example above is very basic but this gives you an idea of how depreciation on a new residential building can assist with your cash flow over the life cycle of a property investment. This may equate to you being able to reduce your loan faster saving interest, or the ability to invest in another property sooner. Also a reminder that to keep it simple, I have not taken into account the benefits of depreciation of all the other items which would generally be available to most property investors, like depreciation on fixtures and fittings, carpets, blinds, dishwashers etc. All of these will only add to the cash flow benefits. A Tip is to ensure you contact a depreciation specialist (Quantity Surveyor) to provide you with a depreciation report, they will ensure you maximise the depreciation on your property and all items within.
Please note that on the sale of the property, depreciation will be added back and could impact on the amount of capital gains tax you will pay. Please contact your accountant for finer details on how this may impact you at that time.
So, when you are next looking at investing in a property, consider the impact of depreciation on your investment as it really is, a little ‘GEM’.
Non Executive Director and Co Founder of Chan & Naylor
Disclaimer: This article contains general information. Before you make any financial or investment decision you should seek professional advice to take into account your individual objectives, financial situation and individual needs.