Depreciation as de facto income

There's plenty to factor in when doing the sums on your property purchase. Top of mind is usually the likely rental income, interest costs and ongoing management costs, such as agent’s fees, rates, insurances and maintenance.
But don’t forget depreciation – an “expense” that doesn’t take money directly out of your pocket – which can have a significant positive impact on your annual cash flow. It’s effectively free, tax office-funded income, particularly if your property was built after 1985.

The following is an extract from Bruce Brammall's new investment book, Investing in Real Estate For Dummies.

Depreciation is the write-off of the cost of an asset over its estimated useful economic life, which allows you to claim a deduction for certain non-cash “expenses” in regard to a rental property because the parts of the assets associated with the investment “wear out” over time. The write-off allows you to claim a portion of the falling value of the asset against your other income.

Depreciation is an expense, but it doesn’t actually take cash out of your bank account. Instead, you treat the depreciation amount as an expense when working out your total income from the property (and, essentially, your total income from all other sources), decreasing your taxable income, and therefore the tax on the income from the property.

Essentially, three types of assets are “depreciated” (for building costs and capital works it’s technically termed an allowance) in relation to investment properties: Building cost (construction cost); capital works; and fixtures and fittings. The rules differ slightly between residential properties and commercial properties and we touch on those differences here.

Technical Stuff: The Australian Taxation Office sets out in its Rental Properties guide, published most years, the current depreciation allowances for residential investment properties. The guide lists more than 230 depreciable items and you’ll find most household items on the list. You can find this list by searching for “rental properties” on the ATO website <www.ato.gov.au>.

Remember: Land is not a depreciable asset. The reasoning is that, even if a house is demolished or destroyed (or blown over a la the Three Little Pigs), the value of the land itself won’t be affected. This principle leads to an important axiom to keep in mind throughout your property investing career: Land appreciates; buildings depreciate.

The tax basis for depreciation is that, from the time an item is bought, that item loses its value through wear and tear. Depreciation takes into account the falling value of an asset by allowing an investor to slowly reclaim a portion of the costs associated with the capital that will eventually be needed to replace the item. Some items lose value faster than others. Although an actual residential building is deemed to have a lifespan of 40 years (see Building cost depreciation following) for the purposes of the capital works allowance, carpets and ceiling fans, for example, are written down over five years and cooktops over 12 years.

Building cost depreciation

Over time, buildings suffer from wear and tear. Although the oldest buildings in any city often rank as the most beautiful, keeping them that way involves considerable maintenance costs. If a house doesn’t receive proper maintenance, it will slowly fall into disrepair. Depreciation allows a property owner to claim back on tax a portion of the cost of the item. (Getting back a portion of its replacement cost is another way of looking at it.)

Two important dates impinge on building cost depreciation when it comes to residential real estate. Where construction of a building commenced before July 18, 1985, no claim for depreciation is allowed for the cost of the bricks and mortar. The other important date is September 15, 1987, after which the original construction cost of the building can be depreciated at
2.5% a year for the first 40 years of the building’s life (after which time, for tax purposes, the building is essentially considered worthless).

Technical Stuff: Between those two dates – about two years and two months – is a period when properties could be depreciated at a higher rate. If you find a property where construction commenced between July 18, 1985, and September 15, 1987, you’ve found a rare property indeed (and that’s not necessarily a positive comment on mid-1980s Australian architecture). Those properties are depreciated at 4% a year over 25 years. Therefore, the depreciation on those properties will have run out by about 2013 – allowing for about a year for completion of the building works if construction commenced just before or on September 15, 1987. The higher depreciation rate is not worth chasing on its own, as the deduction is on building-construction costs for that period, which were a fraction of those costs now.

Warning: Investors can use the construction-cost depreciation to defer and reduce, but not eliminate, tax. Annual depreciation for properties acquired, or structural improvements made, after May 13, 1997, actually reduces the cost basis (calculated as the original cost of the property plus certain other purchase costs and capital improvements) of the rental property. This deduction is partially recaptured (added to your taxable profit) and taxed upon sale. However, it’s still likely to be a tax saving, because you get the depreciation at your current marginal tax rate (up to 46.5%) but, when you sell and the tax is “recaptured”, you pay at CGT rates, paying tax only on half your gain (meaning an effective maximum tax rate of 23.25%). (This applies only on investment properties: no CGT is payable on the sale of the primary residence, nor are depreciation deductions allowed.) Depreciation lowers your income tax in the current year by essentially providing a government interest-free loan until the property is sold.

Technical Stuff: Commercial properties have slightly different depreciation rates for properties built in the early 1980s. And, to further complicate matters, commercial properties are split between whether the premises are industrial or non-industrial. Commercial properties for which construction started after September 15, 1987, are still claimed at 2.5% a year over 40 years. Different rules again apply to residential buildings deemed to be “short-term traveller accommodation”.

Tip: As depreciation is allowed only for the value of the buildings and other improvements, the amount of your depreciation deduction depends on the highest portion of the overall property value being attributable to the buildings. Therefore, it is advantageous to allocate the highest fair market value of your property value to the improvements to increase your potential deductions. But don’t overstate the value. Getting a professional valuer (including a clerk of works, a builder experienced in estimating costs of similar building projects or a quantity surveyor) to do the estimates is advisable. The Tax Office will be suspicious (and may “red flag” you for an audit) if it considers construction-cost depreciation numbers to be too high.

Building-depreciation deductions for both the year of acquisition and the year of sale are for the actual number of days held. That is, if the property was bought on May 10, then depreciation will be for the rest of May and June, or 52 days (to the end of the financial year). If sold on May 10, then it will be for the 314 days of the year already passed. Therefore, if the annual deduction is $2000, then the buyer would get 52/365 of the $2000 deduction, or $284.93.

Tip: Investors are strongly advised to pay to get an expert to compile a “depreciation schedule” (many accounting firms or quantity surveyors will visit the property and create a cost-estimate schedule for about $500–700 for a residential property). Accountants are getting increasingly wary of doing these schedules as part of a tax return, sight unseen, for liability reasons. A property-depreciation schedule will contain estimates of the cost of the building, plus other depreciable items, in a form that will allow your accountant to account for it quite simply. A visit to a property by a depreciation expert will usually pick up things for the schedule that an accountant cannot do from his desk. Quantity surveyors, who are used by building professionals to provide estimates for building construction costs, may also be helpful when providing cost estimates for depreciation purposes.

Capital works

Capital works are those major construction items that may or may not form part of the house itself, but for which the Tax Office will allow a deduction only at the same rate as for bricks and mortar. These works include such things as the driveway, a built-in barbecue, shutters, skylights, water tanks and awnings. These items must be depreciated over 40 years at 2.5% a year.

Remember: Commercial property owners typically modify vacant spaces to get potential tenants to sign a lease. The Tax Office requires that the cost of those improvements be depreciated over 40 years, even if the lease and the actual useful life of the improvements are much shorter. If the tenant moves out before 40 years are up (which most will), the good news is that you can depreciate the full remaining portion of the improvements that are torn out as a result of the tenant vacating.

Fixtures and fittings

A house without fittings is barely a house at all. Finding tenants for a residential investment property without floor coverings (or polished boards), light fittings, a bath or shower and a stove would be difficult.

These items can also be depreciated. In general terms, the Tax Office’s allowances for depreciation of these items will be roughly in line with a reasonable lifespan for the item itself. Carpets, for example, can now be depreciated over five years: 20% of the cost of the carpet can be depreciated each year.

Tip: Get an accountant to calculate depreciation for you. Accountants who spend time dealing with rental properties usually know these numbers backwards. The full list of depreciable items and their rates is also available from the Tax Office website (www.ato.gov.au) Type “rental properties” in the Search window).

Low-value pool

Assets bought for an investment property at relatively low cost can be allocated to the “low-value pool”, for which special depreciation rates apply. The items must be less than $1000 in value (items up to $300 can be fully claimed as an expense in the current year) and items placed in the low-value pool must remain there.

Technical Stuff: Items already in the low-value pool from previous years at the start of a year are depreciated at 37.5% a year at a diminishing rate. Therefore, if five items valued at $2000 were included for the year, the depreciation of those items for that year would be $750 ($2000 × 37.5%). Those items would then start the following year valued at $1250 ($2000 – $750).

Items that are added to the pool for the first time during the year are depreciated at 18.75%. If three items worth a total of $1000 were added to the low-value pool during the year, then a depreciation deduction of $187.50 ($1000 × 18.75%) would be allowed. These items would start the following year valued at $812.50).

Combining these examples shows that an existing pool worth $2000, with $1,000 worth of low-cost goods added during the year, would have a first-year deduction of $937.50 ($750 $187.50). The entire pool would start the following year valued at $2062.50 ($1250 $812.50).

Remember: What sort of items might go into a low-cost pool? Examples include television sets, gas heaters, toilet brushes, small items of furniture, garden hoses and so on. Each item must be worth less than $1000.

Recollection after sale

Although depreciation may feel like free money being handed back from the Tax Office, be sure to note these few important points.

When it comes to fixtures and fittings and the low-value pool, you’re dealing with items that will need replacement at some stage. Microwaves and televisions don’t last forever, nor do carpets. The money you claim back via depreciation is an acceptance of the need to update or replace these items. You can look at the scenario in one of two ways: you’re either getting back a portion of what you’ve already paid for the goods, or you’re receiving a partial pre-payment to help with the cost of replacing the item later.

However, when it comes to building and capital works, if the asset was acquired or the cost incurred after May 13, 1997, a partial recollection of what you’ve claimed as depreciation will be applied if you ever sell the asset. This recollection occurs through a reduction in the “cost base” of the property.

Technical Stuff: Here’s an example: If you bought a property 10 years ago for $200,000 and the cost of the building was $100,000, you may have claimed $25,000 in depreciation over that 10 years ($100,000 × 2.5% × 10 years). You’ve now sold the property for $400,000 – a $200,000 profit. However, as depreciation has been claimed on the building, the property now has a reduced cost base of $175,000, meaning that the profit, as far as capital gains tax is concerned, is $225,000.

You might ask, 'Isn’t this just a case of paying back the tax you claimed earlier?’ The answer is: 'No, not really.’ First, the value of that tax deduction of $25,000 over the years was claimed at your marginal tax rate, or MTR (likely to be between $7875 at 31.5% or $11,625 at 46.5%) against your personal income. But, when paying CGT on the extra $25,000, you pay it only on half the gain, or $12,500 (if the gain doesn’t push you into a higher tax bracket). That would increase the CGT you have to pay by between $3937.50 (at 31.5%) and $5812.50 (at 46.5%), which would still be about half of the tax you claimed as a deduction earlier.

Remember: If you never sell, you’ll never have to repay that portion of the tax.

Technical Stuff: Recent federal budgets have also made depreciation an interesting tax play. Prior to the 2006–07 year, the highest marginal tax rate was 48.5%. If you were in that tax bracket and claiming depreciation, you were claiming back 48.5% of the depreciated amount. If you’re now selling, your MTR should be no more than 46.5% (which is then effectively halved for CGT purposes). In addition, the tax brackets have also been dramatically raised in recent years. For example, you only have to go back to the 2004–05 tax year to have the income level at which the then 48.5% MTR was paid on incomes of just $70,000.

Take an investor who was earning $75,000 a year from his regular job in the 2004–05 year. If he claimed $3000 for building or capital works depreciation that year, he would have received a return of $1455 (48.5%). If he was still earning $75,000 a year in 2007–08 and he sold the property, he would pay a portion of capital gains tax at 31.5% MTR (though any gain that took him above $80,000 would give him a higher MTR). So, on that $3000 reduction to his cost base, he would pay $472.50 in CGT (half of $3000 at 31.5%). If the tax rates hadn’t been reduced and the level at which they cut in hadn’t been raised, he would have paid $727.50 (half of $3000 at 48.5%) on that $3000 deduction, and is therefore now $255 ahead.

Extract taken from Investing in Real Estate for Dummies by Bruce Brammall. Published by John Wiley & Sons.