When a Loss is a Win - Depreciation Explained
When most people think of depreciation, they think of it in terms of a financial loss. And that's not entirely wrong, because depreciation is essentially the loss in a property’s value over time because of ageing and wear and tear.
But for investors, depreciation can actually be a good thing—especially when it comes to property taxes. In Australia, however, depreciation is one of the biggest tax breaks for property investors. It allows you to offset the wear and tear of your investment property against your taxable income.
In other words, it reduces the amount of tax you have to pay—all without having to experience an actual financial loss.
Here’s how.
What is Property Depreciation?
Depreciation is a non-cash expense that can be claimed by owners of income-producing properties. It's based on the idea that, over time, buildings and their fittings and fixtures will deteriorate and lose value.
The Australian Taxation Office (ATO) provides guidelines on what can be claimed as part of depreciation. In general, you can make a claim for structural components of your property as well as plant and equipment.
Claiming a Tax Deduction for the Depreciation of Structural Components
Also known as capital works, these deductions are for the building’s structure and any items
considered permanently fixed to the property, including the building itself and any structural improvements, such as:
fences and retaining walls,
Doors, locks and door handles,
built-in kitchen cupboards,
bricks, mortar, walls, flooring and wiring,
extensions, alterations or improvements to buildings, and
structural improvements.
Capital works can be written off over a longer period than other depreciating assets - usually 40 years. Deduction rates of 2.5% or 4% apply depending on the date on which construction began, the type of capital work, and how it's used.
Depreciation Deductions for the Wear and Tear of Plant and Equipment Assets
Plant and equipment are assets that the ATO deems easily removable, or those that are mechanical, such as:
air conditioning units,
refrigerators,
ovens,
blinds and curtains,
hot water systems, heaters, solar panels,
security systems, and
light fittings.
The depreciation deductions for plant and equipment assets you can claim are spread out over the "effective life" of the asset. For example, the ATO has stipulated that the effective life of a carpet is 8 years. This means that you can claim 25% of the cost of your carpets as a deduction each year for 8 years.
How Do You Calculate Depreciation?
There are two methods used to calculate depreciation deductions: the diminishing value method and the prime cost method:
The diminishing value method results in higher deductions in the early years and smaller deductions in later years. This is because it takes into account the fact that an asset decreases in value over time (hence the name!).
The prime cost method results in equal deductions each year over the asset’s effective life.
And if the asset is worth less than $300, you can claim an immediate deduction in the income year when you bought it.
How Do You Go About Claiming Depreciation Each Year?
To claim depreciation, you will need to get a quantity surveyor to complete a depreciation schedule for your property. A depreciation schedule lists all the plant and equipment items within your investment property and estimates their value at the end of their effective life. It also breaks down all of the building allowance costs.
This report will then be used by your accountant to calculate your tax deductions.
When purchasing a property, you should have your quantity surveyor draw up a depreciation report as soon after settlement as possible. This will ensure that they assess the property in the exact condition you bought it in and will deliver the most accurate depreciation estimates.
Once you have your depreciation schedule, you can then claim the relevant deductions on your annual tax return.
Remember, it’s essential to review and update your depreciation schedule if you do significant renovations.
Key Takeaways
As an investor, it's important to be aware of all the different deductions you may be entitled to in order to maximise your tax return. One of these deductions is depreciation, which is a way of claiming a deduction for the wear and tear of the property over time.
Depreciation can usually be claimed by engaging a quantity surveyor to prepare a depreciation schedule, which itemises all the eligible plant and equipment items in the property that can be depreciated as well as the rate at which you can claim depreciation of the structural components of the property.
So, if you're thinking of claiming depreciation on your investment property, make sure to engage a quantity surveyor; you have nothing to lose and potentially thousands of dollars to gain.
And if you want to know more about the ins and outs of residential property investing, make sure to get your hands on a copy of my book, Residential Property Investing Explained Simply, where I use my analytical insight and investor wisdom to provide a comprehensive breakdown of the residential property investing process.
Alternatively, if you’re still in the market to buy an investment property and would like to know how I’ve successfully helped my clients execute 1,000 residential property acquisitions, get in touch today.