Tax with Max: A troubling investment property question

Why is the value of some investment properties so often distorted?

Summary: Property investors need to distinguish between capital revenue and costs and income revenue and costs. Capital costs are not deductible against the rental revenue produced. But investors may question the effect that claiming a tax deduction for the write off of the construction costs of the building has on the calculation of the capital gain made.

Key take-out: Residential property can be useful from a negatively geared tax perspective but traditionally produces a very low income return.

Key beneficiaries: SMSF trustees and superannuation accountholders. Category: Superannuation.

A troubling investment property question

I am often troubled when I read the one side of capital depreciation of investment properties without balancing the other side of adding back to the cost base of the deducted depreciation. This distorts to the higher side the impression of the worth of getting into this type of investment. I so rarely see anyone reminded to make such adjustments, why is that?

Answer: You have raised an interesting point about property investment and how capital gains tax is calculated when a property is sold. In an effort to put the record straight, and show that as is often the case every benefit does come at a cost, I will try and explain how the immediate benefit of claiming a tax deduction for the write off of building costs does results in a higher taxable gain being made.

There are two types of revenue and costs when a property is purchased for investment purposes. These are capital revenue and costs and income revenue and costs. The capital costs for a property are the original purchase costs and amounts spent by the owner over the ownership period that are not deductible against the rental revenue produced.

One cost that is not tax deductible against rent and is not included as a purchase cost is travel to find a property. This means travelling somewhere to find a property to purchase is a general cost and cannot be included as a cost of the property, which means it is effectively lost money.

Purchase costs that form part of the capital cost include:

  • fees paid to a surveyor, valuer, auctioneer, broker, agent, consultant or lawyer
  • costs of transfer
  • search fees relating to an asset, and
  • the cost of a conveyancing kit

Costs that are not deductible against rental revenue produced mainly include improvements to a property that cannot be classed as repairs. Generally for something to qualify as a repair all of the asset cannot be replaced. When this occurs the cost will more than likely be classed as an improvement.

An example of a repair is where part of a roof is replaced because of storm damage. Where an entire roof is replaced this will in most cases be classed as an improvement. Improvements are also alterations that make an asset better than the condition it was in when purchased.

It is for this reason repairs carried out after purchasing a property, to get it into a condition where it can be rented, are not tax deductible. Where a property has been rented for some time, and work is carried out such as painting to repair damage while it was rented, the cost will be tax deductible against the rental income produced.

At the heart of your observation and question is the effect that claiming a tax deduction for the write off of the construction costs of the building, has on the calculation of the capital gain made.

There have been many changes to the way construction costs can be written off over the years. These changes have resulted in different annual write off rates that depend on the date construction commenced and the type of property. In all cases the rate of write off is done under the prime cost or straight line depreciation method. This results in an annual amount that does not change each year.

For commercial properties such as shops, offices and factories where construction commenced between 21 July 1982 and 19 July 1985 the annual write off is 2.5 per cent. For those properties and income producing residential properties where construction commenced between 19 July 1985 and 15 September 1987 the annual write off is 4 per cent.

For most income producing properties where construction commenced after 15 September 1987 the annual write off has been unchanged at 2.5 per cent. The exceptions to this are manufacturing properties and short term traveller accommodation. Both of these types of properties can be written off at 4 per cent where construction commenced after 26 February 1992.

The ability to claim the tax deduction for construction costs is not limited to the original owner. The annual tax deduction passes from one owner to the next as long as the property is used to produce assessable income.

In some cases the amount that can be claimed as a tax deduction will be provided by the vendor of the property. This amount is often a selling point for properties purchased from developers. In this case the purchaser is given a depreciation schedule that details all costs that can be written off split into fixtures and fittings and construction costs.

In the cases where the vendor does not provide the details of the annual deductible amounts this information can still be obtained. There are quantity surveyors that specialise in providing this information. Investors wanting to maximise their annual property deductions realise the cost of getting a quantity surveyor’s depreciation report is often outweighed by the increased tax deduction and refund.

If you have a rental property and have not had a depreciation schedule prepared all is not lost. You can get a quantity surveyor to prepare one and, as well as including the tax deduction in your next tax return, you can also go back and increase the tax deduction for up to two years.   

Where an investment property was purchased after May 13, 1997, or the construction costs were paid for on a property after June 30, 1999, the amounts claimed as a tax deduction for the construction costs reduce the cost of the property and increase the capital gain made.

A simple example of how the construction costs increases a capital gain is a new residential property purchased in 2000. The cost of the property was $425,000, with additional purchase costs totalling $25,000. The construction cost of the property was $150,000 resulting in an annual construction deduction of $3750.

If the residential property was sold for a net selling value of $1 million in the 2015 year the purchase cost of the property, used to arrive at the capital gain made, will not be $450,000. Instead the total construction costs claimed of $60,000 over the time period that the property was owned is deducted from the original purchase cost. This means the capital gain on this property, not taking into effect the value of fixtures and fittings depreciated over the period of ownership, will be $610,000 and not $550,000.

In this example the owner of the property would be paying capital gains tax at their marginal income tax rate on $305,000. As a result of being able to use the 50 per cent general discount having claimed the construction costs can still result in a net tax benefit. The outcome of this will depend on the marginal tax rate applied to the rental losses. 

The big thing to understand about residential property is that it can be useful from a negatively geared tax perspective, which helps divert income to a growth asset and provides a tax benefit along the way, but it traditionally produces a very low income return. Because of this a residential property can make sense for an investor in wealth accumulation phase but can cause serious problems when an investor is retired.


Max Newnham is a partner with TaxBiz Australia, a chartered accounting firm specialising in small businesses and SMSFs. Also go to www.smsfsurvivalcentre.com.au.

Note: We make every attempt to provide answers to readers’ questions, however, answers are of a general nature only. Subscribers should seek independent professional advice for more in-depth information that is specific to their situation.

Do you have a question for Max? Send an email to askmax@eurekareport.com.au