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Depreciation is an accounting term that accounts for the fall in value due to normal wear and tear.
The Australian Tax Office allows an income tax deduction for depreciation on fixtures and fittings (such as carpet, light fittings, furniture etc.) in investment properties.
Because of this deduction it's possible to have a property that loses money on paper but leaves you with more in your pocket after tax.
This can be a bit confusing, so let's consider the Brian's circumstance as an example.
Brian is employed in a job and earns $70,000 per annum. He's considering buying a property that would rent for $300 per week. Brian estimates that after paying interest and other expenses he would lose about $30 per week, plus he'd also gain depreciation benefits of $50 per week.
Summarising his tax position:
|
Annually With No Property |
Annually With Property |
|
|---|---|---|
| Salary | $70,000 | $70,000 |
| Property Income | $- | $15,600 |
| Property Expenses | ($-) | ($17,160) |
| Subtotal (Cash position) | $70,000 | $68,440 |
| Depreciation | ($-) | ($2,600) |
| Taxable Income | $70,000 | $65,840 |
| Tax + Medicare Payable | $21,330 | $19,307 |
But depreciation isn't a cash outlay, so Brian's overall nett cash position is:
|
Annually With No Property |
Annually With Property |
|
|---|---|---|
| Subtotal (Cash position) | $70,000 | $68,440 |
| Less Tax | ($21,330) | ($19,307) |
| Nett Cash Position | $48,670 | $49,133 |
What this means is that even though the property is negative cashflow, because of the impact of depreciation Brian has more income after tax than if he hadn't invested at all.
So wouldn't isn't this be a good investment?
Not necessarily. There are three issues that need to be explained and carefully considered when evaluating this kind of property investment.
First, while you are left with more cash at the end of the day, you are also more tightly bound to your job in order to earn enough income to pay for the negative cashflow and to have taxable income that the depreciation deductions can offset.
But a harsh reality is that if you lost your job and earned no income, then you'd have to come up with $1,500 to fund the income shortfall over expenses ($15,600 - $17,160), plus you wouldn't be able to make use of the depreciation deductions at all.
The second issue is that this sort of investment is not sustainable if you plan to own multiple properties. For example, let's see what the financial impact of owing 10 of these would be.
|
Annually With No Property |
Annually With Property |
|
|---|---|---|
| Salary | $70,000 | $70,000 |
| Property Income | $- | $150,600 |
| Property Expenses | ($-) | ($170,160) |
| Subtotal (Cash position) | $70,000 | $50,440 |
| Depreciation | ($-) | ($20,600) |
| Taxable Income | $70,000 | $29,840 |
| Tax + Medicare Payable | $21,330 | $5,765 |
But depreciation is a non-cash deduction, so his overall nett cash position is:
|
Annually With No Property |
Annually With Property |
|
|---|---|---|
| Subtotal (Cash position) | $70,000 | $50,440 |
| Less Tax | ($21,330) | ($19,307) |
| Nett Cashflow | $48,670 | $31,113 |
In this case Brian just about wipes out his tax bill, but in doing so substantially reduces his available cashflow to fund his lifestyle.
So the conclusion has to be that as you own more of these properties, your wealth in terms of ability to service your lifestyle diminishes.
Which explains why so many property investors can only afford to own a few properties.
But if owning real estate was such a great idea then wouldn't it make sense that the more you own then the more your profit?
This example highlights why it's so important to know what the likely financial impact of your investment will be well before you buy.
You can do this by using a simple template, included as part of the "Buyer Beware" resource, that walks you through the numbers irrespective of your financial ability.
