The benefits of depreciation, or how wear and tear can be to your advantage

 Although we are several months shy of tax time, I was prompted by some readers to break down tax depreciation, a quite unique tax-advantageous component of property investment, in layman’s terms. By this I refer to the tax allowances for degradation of investment property contents, used to produce income/wealth, for the investor. 

Before you read further I must stress that an investment property is one that you do not live in yourself. It is not your “home”. While some people refer to the home they live in as their greatest “investment” (and indeed it is a great investment!), in the eyes of the Australian Tax Office, this is not an investment property. The biggest (and only) tax allowance you get on your home is the capital gains tax exemption that applies when you sell your home. And no, you cannot own more than one “home” at any one time. You must sell one home, tax-free, before buying another home. 

So back on to depreciation allowances for investment properties – what do I mean by this? 

Well, let’s say you bought an investment property, say it is a brand-new apartment, and say you intend to hold this investment property for 20 years. In the unit, there are the basic walls, cement floors/foundations, ceilings, windows, etc. But then there are other items that deteriorate over time and can require refurbishment and/or replacement over the years. Floor coverings like carpets, perhaps curtains, even stove cook tops, some light fixtures, shower heads and so on. 

Sure, the brand-spanking-new range hood looks great in the apartment now, and your first three or four years of tenants love it, but as the years go on, these items suffer wear and tear that make them less and less valuable. The weaker state of these basic items becomes, over time, detrimental to your potential to continue to lease the property to the best tenant at the best possible rental return. In other words: wear and tear seriously affects your ability to make a profit. 

To compensate for this, the ATO says (very much in a nutshell!) “At the end of every financial year, you can claim some of the weakening value of each item as a tax deduction to help improve your bottom line.” Figuring out how much of a tax allowance you can get for your investment property is not something easily doable by yourself. You are best off to recruit the services of a tax depreciation company. There are many out there, and are all pretty much the same, though do your research and source testimonials on the ones you shortlist before appointing them. The ATO frowns upon those who attempt to conduct a depreciation report themselves, and red flags are raised. In fact (and I’d have to check my sources), it may even be mandatory that a third-party report is required, in order to lodge any tax allowances for depreciable items. 

So when does this need to occur, and what is depreciable, and by how much? The good news is you can purchase a property at any time in the financial year, and so long as you get the report written and lodged with your income tax return, you qualify for any of the tax allowances from the portion of the financial year that you owned the investment property. In fact, the ATO allows back-dating by up to two years, so if you bought a property say 08 months ago, and are panicked, fear not! But if you bought say five years ago, only the last two years’ of depreciation are claimable. 

In regards to what is depreciable and by how much, most items have some depreciable value. To assess this, the depreciator you appoint will need to gain access to the property to conduct an inspection (usually less than 15 minutes is needed). This person determines the “current” value of every item (so, stove, window sills, floor coverings, light fixtures, fences, walls, etc). They then calculate how much “value” each of those items will lose every year, and they will road map this out, per-item, for usually up to 30 to 40 years. So yes, the report can be heavy reading! The good news is you’ll pay for this report just once, and then use the findings contained within for the life of your ownership of the property. Each end of financial year, you submit the same report to your accountant when you do your tax return, and that year’s “allotment” is included in the tax assessment calculation. 

It goes without saying that the figure for say year three, will be much higher than year 27. This is due to the gradual degrading value of items. Think of it like buying a showroom-new car. Buying a new car is better than buying one second-hand, and they look and run the best, however they lose their biggest chunk of value the moment it is driven out of the showroom. Say you spend $30,000 on the brand-new car, but after year one, it is only worth $25,000. But then in year two, it may only lose another $2,000 of value – not another $5,000 of value. Year three may be $1,000, and perhaps it may average out at $500 a year every year after. The same thing applies with depreciable items in property. 

So more often than not, properties that are one to five years old have the most depreciable potential. So, that brand-new stove in the example I mentioned earlier; it may have a year one value of $1,600. The loss in year one could mean for a tax allowance of $180 for that year, but by year 30, this allowance might be only $5. But when you add up all items on the list (in addition to the stove there might be another fifty line-items), it all adds up, and it especially adds up big time, during years one to five. 

For this reason, some investors only consider properties that are aged up to five years old due to their depreciation potential. But it is worth mentioning this is certainly not a strategy that suits everyone, and especially may not suit young investors. Oftentimes, mature investors who are on six- and seven-figure annual salaries see property investment as a way to help offset much of the tax they pay and seek out properties that maximise this. 

For those of us on more modest incomes, this huge tax allowance may not offset the negatives of buying a brand-new property (paying inflated up-front costs, plus also being at risk of increasingly poor-quality construction). Sure, a property may give you no problems in the first few years, but then it may become a money-pit for you thereafter, whereas someone who purchases a 50-year old red-brick apartment block may actually have fewer problems with it. And sure, it would have much lower depreciable value from year one of your ownership of it, yes, but it may cost you less in repairs than some newer buildings. 

While there is no hard and fast rule or strategy to apply, my personal strategy is not exclusive to any type (or age) of dwelling, though I tend to seek properties in the five- to 10-year vintage, mostly because they serve many purposes: 

1)      Usually (but not always) if there aren’t any structural problems by year five, there probably won’t be. Modern constructions tend to show their wear early and up-front, or not at all. 

2)      Years five to 10, depreciation-wise, still provide excellent tax concessions. 

3)      You don’t overpay for the property (you don’t pay the marketing-costs-inflated “brand-new” price, nor do you pay the years two- to three-year “honeymoon” price).

Back to you home owners that I mentioned earlier on. If your strategy is to buy a property to live in but with multiple bedrooms and you intend to rent bedrooms two and three out as an investment component of your home, you will always be entitled to apportioned tax deductions (things like interest on mortgage repayments etc), but at the same time you’ll be up for an apportioned figure of capital gains tax when you ultimately sell your home one day. A tax depreciation report could still be worth investing in, but you’d need to seek specialist advice in this scenario. If you only intend on living in your home for a few years before turning it into a 100% investment property, certainly get the report, but wait until you vacate to actually buy it. 

My overall advice to the community is that when looking at potential investment properties: consider tax depreciation capability when short listing your top three or four. Ask yourself, is the building less than five years old? If it is older, that's OK (even if it is in fact 50 years old). If it is older, does it have a new/recent kitchen? Bathroom? Maybe new fencing, roof tiles, renovations? Extensions? Outdoor paving? These items could have higher tax-depreciable qualities than you first realise. Whenever you do purchase your investment property, be sure to pay the $500 to $1,000 one-time cost to have the report constructed, and do it about 14 days before end of tax year (otherwise if you leave it too late, the results may not come until after the tax year has ended). 

I know I haven’t mentioned just how much you can get back each year, and with good reason: it will be different for everyone, because there are so many variables at play. But I will say this; most people find that they not only re-coup the cost of the report in year one, but they also get a nice return on top within the first year. Plus you get your allotment each year for the next 28 or so years of ownership. So that alone is worth it.

Cameron McEvoy is a property investor and maintains a blog, Property Spectator.