Whether you are buying a brand new property or renovating a rundown dump, understanding depreciation can substantially improve the bottom line of your investment portfolio.
Wiser heads would say that investment decisions should never be made based on tax incentives. The numbers on any investment should stack up without the effect of tax entering the calculations – think of the tax break as a cherry on top.
Nevertheless, tax breaks are often a key driving factor to make property investing affordable to the average person. While some of these tax breaks are currently the subject of polarised debate in the media, depreciation remains one of the better tax breaks available.
Depreciation is essentially a method for calculating the amount assets decrease in value over time (the logic being that you may purchase an asset in year one, but still be deriving value from it in year five or eight). The Australian Tax Office provides guidance on the ‘effective life’ of particular assets – for example, a $5000 computer is allowed to depreciate over four years, resulting in a $1,250 tax deduction per year for that period.
Property investors are able to claim depreciation in two ways, through capital works deductions and depreciating assets.
Capital works deductions refers to the cost of building the investment property (the construction costs). This depreciation is available for 40 years, which is the length of time the tax department says a building lasts before needing replacement. For example, a new building that cost $200,000 to build would give you a tax claim of $5,000 each year for 40 years (i.e. 2.5% per year).
Depreciating assets are defined by the tax department as: “A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. Depreciating assets include such items as computers, electric tools, furniture and motor vehicles.”
For property investors, the usual examples are light fittings, stoves, carpets and even the garbage bin.
The tax office lists all items you can claim and for how long. Known as “the effective life”, this is how long they say it will last before it needs replacement (for example, carpet is listed as 10 years, a kitchen stove is 12 years and a garbage bin is 10 in the current schedules).
Depreciating assets can be calculated using two different methods, the prime cost method or the diminishing value method. The prime cost is the easiest to calculate, as it provides an equal tax deduction each year of the item’s effective life. The diminishing value method allows you to claim higher values in earlier years of the item’s effective life, reducing to smaller ones in later years. Many investors choose this method to provide them with higher depreciation earlier, however you should consult your accountant before establishing which method is best for you.
So how do you claim it?
To claim depreciation you are best served by engaging a professional quantity surveyor with experience in valuing the cost of construction work and fixed fittings. Most will provide a written report on the depreciation available to be claimed on the property, and when it may be claimed. This report can be sent to your accountant for inclusion in your income tax calculations.
And, like many other industries, some quantity surveyors are better than others, so ensure you employ a specialist firm that will actually visit your property.
Don’t throw out the bath before you bank it
But what about renovating? Are there any benefits to be made there too?
There are many websites, books and television shows available that provide tips on how to make cash quickly through renovating property. And while it’s true that you can make a strong return when you sell through clever renovating and recognising an opportunity, many renovators forget to cash in straight away, missing out on money by simply throwing it away.
Typically, renovators get started straight away on ripping out the old to bring in the new. Some get-rich-quick guides would even have renovators complete their work during the settlement period, but that is another story.
So what is the first to go? Typically, you start with the worn down and easily replaceable items – the carpet, blinds and curtains, the appliances such as stoves and dishwashers (regardless of if they are working or not), and light fittings.
On a depreciation schedule for an older property, each taxable item will be assigned a value, for example:
If the renovator is on a 33% tax rate, their tax refund on these items would be $1,475.10. Dumping the items at the tip is literally throwing money away.
Because these items are being scrapped, the full tax deduction is available in year one, instead of the items being depreciated across a number of years, as would normally be the case.
So how do you make sure you do not miss out on any of these tax breaks?
Before you start replacing and restoring, have a depreciation schedule done, then track all the items you dispose of and tell your accountant. These deductions can be claimed in your first year of ownership.
Secondly, once the renovation is complete, have a second depreciation schedule prepared, and ensure you claim depreciation on all the new items.
In one example I saw recently, a renovating couple bought a property to knock down and build again. The depreciation schedule on the old property identified $7000 in tax deductions (or $2,310 tax deduction in the first year). Had they simply bulldozed the property before documenting their situation they would have thrown away more than $2310.
The last word
There can be many savings to be made when you invest or renovate property through proper management of your tax affairs, but make sure you follow the rules. For example, don’t ever claim new items in full if they should be depreciated, and refer to your accountant with any queries in this matter. Repairing items or repainting the walls can be claimed back in the first year, but more tangible and permanent items such as new cupboards or a skylight may be considered part of the building and therefore depreciated over 40 years. For more information on depreciation download the guide for rental property owners from www.ato.gov.au
For more information about Michael Sloan go to: http://www.thesuccessfulinvestor.com.au/
For property calculators and free resources personally developed by Michael Sloan go to: http://www.propertyinvestortoolkit.com.au/
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