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Property Depreciation – Investor’s delight or hidden danger?

Date: 12/01/2014

This investor’s insight article provides a summary of the somewhat complicated topic of depreciation and property investing. As we examine the nature of asset and property depreciation and how it impacts investment returns, you’ll discover that there’s much more to this issue than first meets the eye.

property depreciation
If you own an investment property then the Australian Taxation Office (ATO) will usually allow you to claim a tax deduction for asset and property depreciation.

Depreciation is an accounting term and describes the general wear and tear of an asset, like the carpet wearing, furniture becoming dated etc. that occurs over the time that you own it (also called its ‘useful life’).

Whether or not you can claim a tax deduction depends on the nature of the asset being depreciated. The amount of the depreciation you can claim depends on the method you choose to implement, and an asset’s useful life. These issues are discussed in detail below.


Assets and Property Depreciation

Depending on what the asset actually is, there are two options available for claiming a tax deduction for depreciation relating to your property investment.

assets and property depreciation tax rates

  1. Buildings & Foundations
  2. As you’d expect, the actual building suffers wear and tear and generally qualifies for a write down under capital works provisions.

    Capital works is a broad term that covers various constructions, extensions, alterations and improvements of a structural nature.

    The rules in this area are quite complex. It’s not as simple as buying a pre-existing house and then claiming a capital works deduction.

    Given the tricky nature, you’ll need to ask your accountant for more specific information for your circumstance.

    If you do qualify for a write-off, then the rate is usually 2.5% per annum (so the building is fully written off after 40 years).

  3. Other Depreciating Assets

Assets relating to your property investment (other than things that relate to the structure of the building) that have a finite life and fall in value through regular use can generally be depreciated over their useful life.

assets depreciation and property depreciation
For example, an investor may claim a tax deduction for the wear and tear of fixtures and fittings such as carpet, appliances (fridge, stove etc.), light fittings, furniture and the like.


Ways of Calculating The Deduction For Other Depreciating Assets

The ATO provides two acceptable methods for calculating depreciation on plant and equipment

  1. Prime Cost
  2. The first method is called ‘prime-cost’.

    This method assumes that the asset experiences even wear and tear over its useful life and accordingly a constant rate is applied.

  3. Diminishing Value

The alternative method available is known as ‘diminishing value’.

It assumes that an asset wears down more in its earlier years of use and accordingly allows for higher depreciation write-offs in the beginning, and less depreciation later on during the asset’s life.


Tax Rates

The ATO has published prescribed depreciation rates depending on the useful life of the asset and the method chosen.

For the prime cost method, the rate is calculated by dividing 100% by an asset’s useful life in years. So the prime cost depreciation rate for an asset expected to last four years is 25% (100% / 4).

For the diminishing value method, the rate is calculated by dividing 150% by an asset’s useful life in years. So the diminishing value depreciation rate for an asset expected to last four years is 37.5% (150% / 4).


Example highlighting the different methods

property depreciation depreciation and investing
It’s time to test your knowledge!

Imagine that you purchased $1,200 worth of furniture (with a useful life of five years) for your investment unit on 1 July 2002. Use this information outlined so far to answer the questions below:

What Is The Annual Depreciation Rate?

Prime Cost: % Check Diminishing Value: % Check
Solution: Solution:
100% / 5 = 20% 150% / 5 = 30%

What Is The Depreciation In The First Year?

Prime Cost: $ Check Diminishing Value: $ Check
Solution: Solution:
$1,200 * 20% = $240 $1,200 * 30% = $360

What Is The Depreciation In The Second Year?

Prime Cost: $ Check Diminishing Value: $ Check
Solution: Solution:
$1,200 * 20% = $240 ($1,200 – $360) * 30% = $252

What Is The Depreciation In The Third Year?

Prime Cost: $ Check Diminishing Value: $ Check
Solution: Solution:
$1,200 * 20% = $240 ($1,200 – ($360+$252)) * 30% = $176.40

What Is The Depreciation In The Fourth Year?

Prime Cost: $ Check Diminishing Value: $ Check
Solution: Solution:
$1,200 * 20% = $240 ($1,200 – ($360+$252+$176.40)) * 30% = $123.48

 

What Is The Depreciation In The Fifth Year?

Prime Cost: $ Check Diminishing Value: $ Check
Solution: Solution:
$1,200 * 20% = $240 $76.80 (Remaining Balance or
($1,200 – ($360+$252+$176.40+$123.48)) * 30% = $86.44)

 

Note: Under the diminishing value method the asset still has some value at the end of its useful life which is further depreciated in later years. Under the prime cost method it is fully depreciated at the end of its estimated working life. This is just an anomaly in the two different methods. Taxpayers nevertheless often choose to adopt the diminishing value depreciation method as it allows for higher deductions in the earlier years.


Depreciation And Investing

To explain why most investors like the prospect of asset and property depreciation we need to build a case study.

Shannon part-owns and operates a floor tiling business in the Eastern suburbs of Melbourne. She is paid a base salary of $50,000 per annum, plus she is entitled to a profit share which for the year ended 30 June 2002 came to a further $25,000. Her superannuation contributions are on top of her salary.

Two years ago Shannon attended a free seminar and was convinced of the merits of buying an investment property. She signed a contract to purchase a one bedroom inner city flat for $260,000 (inclusive of closing costs) on the basis she pay a 10% deposit and the building would be ready for rent on the 1st July 2001 at $300 per week.

The developer offered a 7% rental guarantee for three years provided Shannon use their preferred rental managers who charge a commission of 8.5%. The rates and miscellaneous costs totalled $2,500 per annum during the first year.

Shannon’s property came with a $30,000 fit out which included designer furniture, imported carpet and modern appliances. These assets have an expected useful life of ten years from the date of first use, at which point it is expected to be worth next to nothing. She is also entitled to a capital works tax deduction based on a building construction cost of $180,000.

Shannon’s property is financed via a 90% loan ($234,000) at an interest rate of 6.7% per annum (interest only). Her loan repayment is $301.50 per week.

Using this information and assuming Shannon uses the prime cost method of depreciation, have a go at trying to complete her summary of property income and expense for the tax year ended 30 June 2002:

Summary of Property Income & Expense
For the Tax Year Ended 30 June 2002.

Item Your Answer Solution
Rental income Solution $15,600
Rental Management Solution ($1,326)
Loan Interest Solution ($15,678)
Rates etc. Solution ($2,500)
Cashflow Loss Solution ($3,904)
Fit out depreciation1 Solution ($3,000)
Capital works deduction2 Solution ($4,500)
Tax Loss Solution ($11,404)

1. $30,000 * (100%/10) 10% = $3,000
2. $180,000 * 2.5% = $4,500

Given the solution above, a summary of Shannon’s tax position is:

Shannon with
no property
Shannon with
one property
Salary $75,000 $75,000
Property tax loss ($11,404)
Taxable income $75,000 $63,596
Total Tax + Medicare ($23,755) ($18,224)

Using this information we can build an after-tax summary to establish whether or not Shannon has created wealth with her property investment.

Shannon with
no property
Shannon with
one property
Salary $75,000 $75,000
Cashflow loss ($3,904)
Income tax ($23,755) ($18,224)
After-tax cashflow $51,245 $52,872

So, what can we say?

Despite the fact that the property is negative cashflow to the tune of $1,627 per annum, Shannon nevertheless has more after-tax available ($52,872 compared with $51,245) by buying this property than compared with choosing not to invest in anything!


Assets & Depreciation

How Depreciation Works

Shannon is able to benefit because her non-cash depreciation deductions of $7,500 to lower her total income tax payable.

Remember that Shannon has only paid 10% of the total fit out cost ($3,000 through her deposit), but can nevertheless use 100% ($30,000) of the fit out cost as her depreciation cost base. Plus she can also claim a tax deduction for the interest cost on the fit out ($27,000 * 6.7%) too (as part of the overall loan interest).

Conclusion

Is it appropriate to conclude that asset and property depreciation is always good? Well, not quite.

Depreciation is only a tool. When used properly it can be a great resource for investors. But if it is used poorly then it becomes a double-edged sword, sometimes helping, sometimes hurting unwary investors.

property depreciation dangerThe Dangers of Depreciation


Don’t forget what depreciation represents!

It can be tempting to sit back and claim a tax deduction without understanding what it exists to represent.

Depreciation is an accounting allowance used to match the cost of an asset with the income that it generates over its useful life.

Hmmm… this might seem like ‘accounting-speak’, so another way of looking at it is this: Depreciation generally assumes that once an asset’s useful life has finished then it will soon need replacing.

So even though depreciation is not a physical cash expense, it represents the apportionment of the asset and signals that one day it will need to be replaced using real dollars which you’ll have to pay or fund yourself.

One of the big mistakes Ansett made was to claim depreciation on planes but not make a cash provision for the replacement of the asset when its useful life expired. In the end they were left with an ageing fleet that cost a lot of money to maintain.

The warning message here is by all means claim asset and property depreciation, but remember that it is not a bonanza that will last forever. One day the asset will need replacing, or, at the very least, more money to maintain it. When this occurs you’ll need to fund it from your savings or else borrow more money.

property depreciation assets depreciateExpensive Fit Outs Soon Lose Their Gloss

The property that Shannon purchased came with snazzy carpet and other mod-cons typically designed to attract a premium tenant who will pay above-market rents.

This might be true, but the appeal of the fit out will fade in time once the appliances are used and the property has been lived in. It’s just like what happens when you drive the new car out of the showroom.

A fatal flaw in the ‘premium tenant’ argument is that premium tenants may shift to newer and more exciting places of abode when their lease expires. This means that if you want to keep your tenant or attract a new premium one then you may need to allow for a new fit out every five or so years to keep the place modern and functional.

And this isn’t necessarily a problem so long as you know about it up-front. Sadly many investors don’t and have a nasty surprise waiting for them when a lease expires.

Limit On The Maximum Benefit Available

Depreciation benefits are only of use while you have tax to offset. Once you have wiped out your tax liability then your depreciation benefits lose a lot of their appeal.

To understand this we need to again revisit Shannon’s situation and see what happens if she had decided to buy 3, 5 and even 10 of the same properties, assuming that she had the money available to fund the necessary deposits.

 

Summary of Property Income & Expense
For the Tax Year Ended 30 June 2002.

# Properties:
Item Three Five Ten
Rental income $46,800 $78,000 $156,000
Rental Management ($3,978) ($6,630) ($13,260)
Loan Interest ($47,034) ($78,390) ($156,780)
Rates etc. ($7,500) ($12,500) ($25,000)
Cashflow Loss ($11,712) ($19,520) ($39,040)
Fit out depreciation (1) ($9,000) ($15,000) ($30,000)
Capital Works deduction2 ($13,500) ($22,500) ($45,000)
Tax Loss ($34,212) ($57,020) ($114,040)

1. $30,000 * (100%/10) 10% = $3,000 per property
2. $180,000 * 2.5% = $4,500 per property

Given the solution above, a summary of Shannon’s tax position is:

# Properties:
Item Three Five Ten
Salary $75,000 $75,000 $75,000
Property tax loss ($34,212) ($57,020) ($114,040)
Taxable income $40,788 $17,980 $0
Total Tax + Medicare $9,228 $2,306 $0

Using this information we can build an after-tax summary to establish whether or not Shannon has created wealth as her property portfolio expanded.

# Properties:
Item Three Five Ten
Salary $75,000 $75,000 $75,000
Cashflow loss ($11,712) ($19,520) ($39,040)
Income tax ($9,228) ($2,306) $0
After-tax cashflow $54,060 $53,174 $35,960
The conclusion we can reach is that as Shannon buys property like the inner city apartment outlined above, her after-tax cashflow falls.
In the beginning she is actually better off than not investing at all, which is still the case by owning five properties, however once her income tax has been eliminated then she is substantially worse off as far as after-tax cashflow is compared.

What does all this mean?

It means that by purchasing negatively geared property with depreciation benefits, Shannon becomes reliant on her high paying job to make up for the depreciation deductions that no longer generate tax relief.

asset and property depreciation concept
This is fine if Shannon wants to keep working for the foreseeable future, but it is contrary to the notion of financial independence which works on the basis of investing to create an income that is independent to your job and frees you from the obligation of work.
Again there is nothing wrong with this investing technique and it must be said that if Shannon achieved capital growth while owning the property then she would have created substantial paper wealth and experienced a big increase in her nett worth.
But if your goal is to work less sooner rather than later, then buying negatively geared property does not align itself with the outcome you are trying to achieve.

Not An “All Season’s Strategy”

property depreciation negative gearing strategy
Negative gearing works best in markets when prices are rising steadily.

However the property market moves generally upwards but does suffer from times when price rises are non-existent.

During these times investors need to ride out the bumps, which is fine if you can maintain your job.

But should you lose your job then you will nevertheless still need to fund the negative cashflow from your own pocket. If you can’t find another job then the tax benefits will lose their shine since you have no tax payable to offset.
Investors who are unlucky enough to find themselves in this position may need to sell their asset to eliminate the negative cashflow noose that owning property has created. And it’s the investors who have to sell in a down market who stand to lose the most by being forced to sell at a reduced price.
If you do decide to buy a negatively geared property with depreciation benefits then the key is to manage your risk by being careful not to extend yourself financially by trying to eliminate your tax.

There Is An Alternative!

Negative gearing is not the only property investing strategy where asset and property depreciation can provide tax benefits.
It actually works just as well (and has the same dangers!) when it comes to <positive cashflow> property investing.
However because the focus of positive cashflow investing is making cashflow returns from day one rather than eliminating tax and securing capital gains, asset and property depreciation deductions are seen as gravy on the deal rather than an essential component.
Just on this, while there may be an adequate reason for some investors to buy a negatively geared property (such as trying to save tax vs. seeking to reduce the need to work in a job), there’s a variation of the positive cashflow investing strategy that allows for both capital gains and cashflow returns.
It’s not about the tactic you use (buy and hold, wraps, flips, lease-options or renovations), rather it’s about careful management of the flow of money that your investing creates.

property depreciation there is an alternative
This proven wealth creating strategy is discussed in full in <Property Secrets Revealed>


The Final Word

Asset and property depreciation is neither good nor bad since the effect that it has on an investor’s after-tax income depends on the type of property being purchased and his/her salary income.
It can have the effect of reducing tax and increasing after-tax available cashflow. But even in the best case scenario, trying to eliminate tax with depreciation and income losses will only further bond you to the need to work.
The final word in this matter is that you need to review what outcome you desire from your investing strategy. If purchasing a negatively geared property fulfils your needs, then great! But before you launch in and purchase multiple properties remember:
  • It’s not all roses! Depreciation is an allowance for the replacement of an asset. If you take the deduction and don’t allow for the asset’s replacement then you might end up like Ansett.
  • Using asset and property depreciation to wipe out your tax liability will actually result in you having to retain your job, which is not consistent with the idea of financial independence.
  • There is an alternative method of investing, <positive cashflow>, that is as equally acceptable and offers a totally different outcome.
Profile photo of Steve McKnight

By Steve McKnight

Steve McKnight, the founder of PropertyInvesting.com, is a respected property investing authority as well as Australia's #1 best-selling business author.

Comments

  1. Judi minett

    I wish I had read this very understandable explanation of the pros and cons of buying an investment property, before entering into a purchase. Brokers do not necessarily explain the entire picture, but sell an idea purely of a positive nature in regard to both current and expected financial stability. If you don’t know the questions to ask, you can find yourself in an abyss of financial distress.

  2. Profile photo of bxvcb

    hi Steve i am in high income bracket 230000 per year and end up paying 48% tax. I bought a negative gear new property to reduce my tax and claim depreciation benefits. i have a stable job and plan to work atleast next 15years. Is this the right strategy??

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