As the owner of a residential investment property, unitholder of a property trust or an entity that owns investment properties, understanding the types of depreciation in real estate will enable you to take full advantage of the depreciation deductions available. Claiming maximum depreciation deductions can make a significant difference to cash flow by reducing assessable income in the financial year they are applied.
The Australian Taxation Office (ATO) allows owners of income-producing properties to claim depreciation deductions for the natural wear and tear that occurs to a building and the items within it against their assessable income. Depreciation tax breaks are generally higher on newer properties when utilising the diminishing value method which applies a higher rate of depreciation in the initial years of owning the asset. Depreciation, however, is available for all types of investment properties and is crucial for maximising deductions.
To claim depreciation, property owners must arrange for an accredited quantity surveyor to inspect the property and prepare a property tax depreciation schedule. On-site inspections are necessary to satisfy ATO requirements. The schedule lists all the depreciable items, including the effective life left in each item and the dollar value which can be claimed against your assessable income. It will include depreciation on both the building allowance (structural) and plant and equipment as well as capturing any renovations made to the property since initial construction. You can learn more about a property depreciation schedule and what owners may be entitled to here.
With tax time approaching, we’ve answered some of the most frequently asked questions relating to types of depreciation. Real estate investors should seek independent advice from a tax accountant or professional to help you better understand property depreciation and the deductions you may be entitled to based on your individual circumstances. Investors in property trusts should also seek information from their fund manager for general information and from a tax accountant for advice on their personal circumstances. For Trilogy Funds investors, details can be found in our annual tax statement and our Investor Relations team is available to help with any investor queries.
What is depreciation?
Depreciation is a key element of an investment property strategy, so it’s important to understand what it means. According to the ATO, ‘a depreciating asset is one that has a limited effective life and can reasonably be expected to decline in value over the time it’s used.’
As a property gets older, the building’s structure and the assets within it wear out. In this context, property depreciation is an allowable deduction that provides investors the ability to offset their investment property’s decline in value from their taxable income.
What are the types of depreciation?
Depreciation deductions are split into two distinct categories:
- Division 43 – Capital Works Allowance
Capital works may include the building or extensions, alterations or improvements to a building and the allowance refers to claims for the wear and tear that occurs to the structure of the property, including any fixed items such as the brickwork, roof, walls, doors and kitchen cupboards.
Property owners of income-producing properties are entitled to claim a capital works deduction. The percentage of deduction and the number of years it can be claimed are determined by the type and date of construction as well as the intended use of the building. The ATO provides information regarding limits to claiming capital works deductions and important factors that help to work out claims here.
As a general guide, property investors who own residential properties built after 15 September 1987 can claim capital works deductions at a rate of 2.5% per annum for 40 years. For residential properties which have undergone structural improvements after 27 February 1992, investors can claim a capital works deduction for the cost of construction at 2.5% per annum for 40 years from the date construction was completed.
For commercial and industrial properties, capital works deductions can be claimed at either 2.5% or 4.0% per annum. The rate is determined by the date construction commenced, the type of capital works and the nature of use.
It is important to note that claiming capital works allowance depreciation deductions may affect your Capital Gains position on your asset. It is essential to seek independent advice from a professional for your personal circumstances.
- Division 40 – Plant and Equipment Depreciation
Plant and equipment depreciation is claimable on removable fixtures and fittings within a property. The ATO recognises more than 6,000 different depreciable assets, including items such as carpet, blinds, air conditioners, hot water systems, smoke alarms and ceiling fans. Depreciation deductions for these assets are calculated on their individual effective life, as set out by the ATO.
Under current legislation, owners of second-hand residential properties who exchanged contracts after 7:30pm on 9th May 2017 cannot claim deductions for previously used plant or equipment assets. Investors who purchase brand-new residential and substantially renovated properties or add new plant and equipment assets to a second-hand residential property can still claim substantial depreciation deductions.
Commercial and industrial property owners can claim depreciation on any assets they own within the property. Any applicable deductions will be subject to the quantity surveyor report.
What methods are used for calculating depreciation?
Broadly speaking, plant and equipment assets costing $300 or less can generally be claimed as immediate deductions, while assets costing over $300 must be depreciated over their estimated useful life. It’s important to note that these deductions are subject to a number of tests from the ATO which you can learn more about here.
To calculate the amount of depreciation that can be claimed on plant and equipment assets within an income-producing property, there are two methods which can be used:
- Prime Value
The prime value method (also known as the straight-line method) stipulates that owners can claim a fixed percentage of the value of the asset for the duration of the asset’s effective life. Using this method allows owners to claim a lower but more constant proportion each year.
- Diminishing Value
The premise for the diminishing value method is that the decline in value each year is a constant proportion of the remaining value and produces a progressively smaller decline over time. Using this method allows owners to claim higher deductions in the early years of the asset’s effective life.
There are two areas which the decline in value will be applied:
- Accounting Depreciation
Accounting depreciation (also known as book depreciation) accounts for the decline in the asset values within a business’ financial records. Effectively, the depreciation of these assets is an expense to the business and should be included as such when calculating profit. Accounting for the decline in assets will give a true indication of a business’ financial position.
- Tax Depreciation
Tax depreciation is the process of applying the decline in asset value in accordance with tax legislation. The tax depreciation is reflected in an investor’s annual tax statement in the form of tax-deferred amounts or reduced assessable income and is generally the second biggest deduction for property investors, after interest.
How does depreciation affect my property trust investment?
Property fund investors who are Australian residents for tax purposes may be entitled to receive tax-deferred amounts, reducing the amount of income tax payable from an investment trust in a given financial year. Tax-deferred distributions generally arise due to non-cash deductions or tax concessions such as depreciation. Income tax may not be payable on tax-deferred amounts, with the tax liability being deferred until a capital gain (if any) is realised.
The ATO has significant data matching and information-gathering capabilities covering many capital transactions and investment revenue streams. It is important to report investment income accurately, including from overseas, maintain accurate records, correctly calculate capital gains or losses and comply with the various rules and concessions available to you as an investor.
What happens to the depreciation claims once the building is sold?
Once an investment property is sold and settlement is complete, the seller can no longer claim depreciation and the existing depreciation claim is factored into the sale calculation. Any remaining capital works entitlements will pass on to the next owner if they continue to use the property for income-producing purposes.
When selling a property, investors will need to consider the capital gains tax (CGT) implications. CGT is a tax charged on the profit, or capital gain, made from the sale of an income-producing asset. CGT is very complex, with a multitude of factors affecting its application, including when the property was acquired. You can read more about Capital Gains Tax here.
The information in this article contains general information and does not take into account your personal objectives, financial situation or needs. Trilogy Funds does not purport to provide tax advice. We recommend that you consult a licensed Tax accountant if you require financial advice that takes into account your personal circumstances. While every effort is made to provide accurate and complete information, Trilogy Funds Management Limited ABN 59 080 383 679 AFSL 261425 (Trilogy Funds) does not warrant or represent that the information in this article is free from errors or omissions or is suitable for your intended use. Subject to any terms implied by law and which cannot be excluded, Trilogy Funds accepts no responsibility for any loss, damage, cost or expense (whether direct or indirect) incurred by you as a result of any error, omissions or misrepresentation in this information. Note: All figures are in Australian dollars unless otherwise indicated.