You are here

Claiming Depreciation on Investment Property: The property investor's complicated friend

Residential property investors are in the business of making money, and depreciation is an important component of a property’s profitability. Yet depreciation is also something of a mystery to many investors and is subsequently overlooked, together with many thousands of dollars in potential tax deductions. This resource explains depreciation in detail so our investors can be confident in claiming every cent they are entitled to.

 

Author: Peter Gianoli, General Manager Investor Assist

Introduction to investment property depreciation

As investment properties get older and the items within them suffer wear and tear, they decline in value. The Australian Taxation Office (ATO) recognises this and allows investors to claim this loss of value as a tax deduction against their assessable income. This is called depreciation of investment property.

Just as you would deduct your interest payments and the costs of maintaining an investment property, you are allowed to deduct the depreciating value of the property itself and the items within it. Investment property depreciation is known as a ‘non cash deduction’ because it doesn’t require any ongoing payments such as interest. The deductions are built in with your investment property – so if you don’t claim depreciation in your tax return, you are missing out on a genuine entitlement. It’s your job to claim it, and the ATO does not issue reminders.

The major benefit of depreciation is improving cash flow, by reducing taxable income. Depreciation of investment property itself is not necessarily a reason to invest in a property, but when claimed correctly it can make your property investment easier to manage and free up cash for further investment opportunities, thus helping you to build a portfolio faster.

Is depreciation worth it? Here’s a very simple example

By way of demonstration, at the time of writing a newly built, 160sqm brick and tile property was constructed at the cost of approximately $190,000, comprising the following:

  • $160,000 of building structure
  • $30,000 of Depreciating Assets (such as floor coverings, blinds and appliances).

The Capital Works Allowance on this property (2.5% of the building cost) works out to be $4,000 per annum. The Depreciating Assets are more complex to calculate since they depreciate at different percentages, but in total they come to $4,200 in the first year.

This means, in the first year alone, a depreciation deduction of $8,200 can be offset against the investor’s assessable income, resulting in reduced tax liability and increased cash flow.

Clearly, depreciation is important, yet it is also complicated. There are an enormous number of rules that have been added to over time, and it’s therefore advisable to get assistance and advice from qualified professionals. The rules vary for different types of buildings – residential, non-residential, manufacturing and short term traveller’s accommodation. The focus of this article is on residential investment properties and the types of depreciation investment property can offer.

The components of a investment property depreciation schedule for residential investment properties

There are two major components of an investment property depreciation calculation – the Capital Works Allowance and the Depreciating Assets within the property. The ATO also refers to these respectively as Division 43 and Division 40. The Capital Works (Division 43) allowance is the deduction available for the building’s structure, along with fixed assets such as built in cupboards. Essentially, this is anything that is a permanent fixture or cannot be removed easily from the property.

Depreciating Assets (Division 40) are items commonly referred to as ‘plant and equipment’, or ‘plant and articles’. Loosely these assets are any item that can be picked up or easily removed from an investment property, such as curtains and hot water systems.

The distinction can sometimes be difficult. Many assets we consider to be one object – such as air conditioning – are actually made up of both Division 43 and Division 40 components.

Below we explain each category in detail.

Capital Works Allowance (Division 43)

The Capital Works allowance is the deduction available for a building’s structure and any fixed assets. In terms of the building structure this includes the actual brickwork, timber work, roof and footings. Fixed assets can loosely be described as items that can’t be easily removed from the property, such as built in cupboards or plumbing fittings.

The Capital Works Allowance is applicable to buildings built after 17 July 1985, and for most properties is set at a flat rate of 2.5% per annum, claimable over 40 years. Properties built until 15 September 1987 were able to be depreciated at 4% for 25 years. You can only claim deductions for the period during the year that the property is rented or is available for rent. If you live in a property and intend to rent it out in future, investment property depreciation is not available to you until it is used for rent generation.

The Capital Works Allowance is determined by age of the assets and the type of construction. The laws have been added to progressively over the years – the most relevant additions are as follows.

Start of construction Type of construction able to be claimed
18 July 1985
Any building intended to be used on completion for residential purposes or
to produce income
27 February 1992
Structural improvements intended to be used on completion for residential
purposes or to produce income
After 30 June 1997
Any capital works used to produce income (even if, on completion,
it was not intended that they be used for that purpose)

It is worth noting these dates prior to purchasing an investment property built around these eras. The construction date is a primary factor. Yet structural improvements can also be valuable in terms of depreciation of investment property allowances. Many older properties have had significant structural improvements such as new kitchens, bathrooms and outdoor renovations over the years. As long as they were completed after 1992, they are claimable under the Capital Works Allowance and could amount to significant tax deductions.

Fixed assets

The ATO has a comprehensive list of fixed assets on their website that qualify for the Capital Works Allowance. The following is by no means an exhaustive list but is a good starting point:

  • Built in cupboards
  • Clothes hoist
  • Door and window fittings
  • Driveways and paths
  • Electrical wiring
  • Fencing and retaining walls
  • Floor and wall tiles
  • Garages and non-portable sheds
  • In ground swimming pools and spas
  • Plumbing and gas fittings
  • Reticulation piping
  • Roller door shutters
  • Roof top ventilation and sky lights
  • Permanently fixed security doors and screes
  • Sinks, baths and toilets.

Construction and building costs

When working out the construction cost of a building or other capital works you must use the actual or historical construction cost. This is not the same as the purchase price of the building, or even the insured cost or replacement cost. The types of expenses that can be deducted include:

  • Building construction cost
  • The cost of altering a building, such as adding an internal wall, kitchen renovations or bathroom makeovers
  • The cost of capital improvements to the surrounding property - such as a gazebo, carport, sealed driveway, retaining wall or fence.
  • The ATO suggests the following types of fees are inclusive in this cost:
  • Preliminary expenses such as architects’ fees, engineering fees and the cost of foundation excavations
  • Payments to carpenters, bricklayers and other tradespeople for construction of the building
  • Payments for the construction of retaining walls, fences and in-ground swimming pools.

There are specific costs not able to be claimed under the Capital Works Allowance. These include the costs associated with acquiring land, demolishing existing buildings, preparing a construction site prior to excavating (eg earthworks that are not integral to the installation or construction of a structure), and landscaping works. In addition, you cannot claim any value placed on your contribution as owner / builder to a project.

Evidence required to claim construction costs

The ATO requires the following types of information relating to the Capital Works Allowance:

  • Commencement and finish dates of construction
  • The type of construction
  • Information on your builder
  • The actual construction cost – by way of receipts or detailed listing of costs, or a report prepared by a qualified individual.

The ATO has specific rules about who is qualified to estimate construction costs of a building. The legislation specifically states that, “Unless they are otherwise qualified, valuers, real estate agents, accountants and solicitors generally have neither the relevant qualifications nor experience to make such an estimate.”

The following types of professionals are deemed by the ATO to be appropriately qualified to provide this information:

  • A quantity surveyor
  • A clerk of works (eg a project manager for a building project)
  • A supervising architect who approves payments at each stage in a project
  • A builder who is experienced in estimating construction costs of similar building projects.

Depreciating Assets (Division 40)

Depreciating Assets can be described as any item that can be picked up or easily removed from a residential investment property. These items are commonly referred to as ‘plant and equipment’ or ‘plant and articles’. Some research suggests that Depreciating Assets make up anywhere up to 35% of the overall cost of a residential building.

The ATO recognises these types of assets lose value over time and therefore investors should be able to claim a deduction. However, while the ATO uses a flat 2.5% for the Capital Works Allowance, it stipulates that Depreciating Assets lose value at varying rates, and so has defined an ‘Effective Life’ for over 1,500 assets to help investors calculate their investment property depreciation schedule.

Investors are allowed to use two methods to calculate the amount of decline in value of Depreciating Assets each year – the ‘Prime Cost Method’ or ‘Diminishing Value Method’. More detail on these methods can be found below.

Given there are so many types of Depreciating Assets, the ATO allows investors to group low cost assets together to make the process easier. Items costing between $300 and $1,000 fall into what is called a ‘Low Value Pool’ and attract a higher depreciation rate. In addition, items costing less than $300 can be written off in the year of expense.

Effective life of Depreciating Assets

The ATO gives Depreciating Assets an ‘Effective Life’ to determine how many years investors can depreciate them for. Effective Life is part of the calculation used to work out deductions for plant and furniture in an investment property.

The ATO says the Effective Life has regard for reasonable wear and tear, and is estimated to be the time taken from purchase (not from the time you start using it in your investment property), until the item is likely to be sold for no more than scrap value.

Some examples of common Depreciating Assets and their Effective Lives are as follows:

DECPRECIATING ASSET EFFECTIVE LIFE (YEARS)
Ceiling fans  5
Cook tops 12
Digital video display (DVD) players  5
Furniture, freestanding  13 1/3
Garbage bins  10
Garden sheds, freestanding  15
Hot water systems (excluding piping):  
Electric 12
Gas 12
Solar 15
Ironing boards, freestanding  7
Microwave ovens  10
Mirrors, freestanding  15
Television sets  10
Ventilation fans  20
Window blinds, internal 10
Window curtains 6

 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Some assets are not issued with an Effective Life and it is up to the investor to determine a reasonable Effective Life calculation. The ATO provides guidelines in these instances.

Choosing the most effective Depreciating Assets when renovating

The rules about Effective Life provide flexibility for investors to maximise their depreciation allowance in the short term when renovating an investment property. For example, although there are aesthetic reasons to choose a certain type of floor covering, the more important consideration may be how much of a deduction for depreciation of investment property is allowable in the short term.

Below is a comparison of the deduction available in the first financial year, based on spending $2,000 on floor coverings and light fittings. And while tax deductions will not necessarily be the primary factor in renovation decisions, this is food for thought for investors with a short investment time frame.
 
Asset EFFECTIVE LIFE DEDUCTION IN FIRST YEAR
Floor coverings    
Carpet 10 years $400
Floating timber 15 years $267
Tiles 40 years (capital works) $50
Lighting    
Other light fittings 5 years $800
Hardwired (eg down lights) 40 years (capital works) $50

Calculating deductions on Depreciating Assets: the Prime Cost and Diminishing Value methods

The ATO allows the use of two different methods to calculate deductions for Depreciating Assets in a residential investment property. The Prime Cost method assumes assets depreciate in value in a straight line (the same deduction each financial year), while the Diminishing Value method assumes assets depreciate faster in the short term, and progressively less. Both methods are based on the Effective Life of an asset and both claim the same total value over 40 years.

 
Prime Cost method Diminishing Value method
Assumes assets experience even wear and tear
Assumes that an asset wears down more in its earlier
years of use
A constant percentage rate is applied for each financial
year of an asset’s Effective Life
Returns higher deductions in the first few years and a
progressively smaller decline over time
Returns higher deductions in the latter years of a 
depreciation schedule compared to Diminishing Value
Utilises low value pooling to increase the claim on items
under $1,000
Allows investors to rely on a more consistent
depreciation claim each year
Commonly adopted by investors with a short term
ownership strategy, for example less than 5 years.
May be suited to investors who plan to hold their
investment property for the long term, or maximise
deductions in later years.
 

The Prime Cost and Diminishing Value calculations

To work out annual deductions using the two methods you need the following information:
  • Asset cost – the initial cost of the asset (when using the Prime Cost method)
  • Base Value – the Asset Cost minus the previous year’s claim (for the Diminishing Value method)
  • Number of days held – this is how many days in the financial year the asset has been used for income purposes. Normally this is 365 (or 366 in a leap year) but for new assets it would likely be less than 365. Eg for an asset bought on 1 January the days held for that year will be the remaining number of days until 30 June
  • Effective Life – the ATO lists suggested Effective Lives for over 1,500 assets on its website.
 
To work out annual deductions under the Prime Cost method, use the following calculation:
Asset Cost x Days Held/365 x 100% Effective Life
 
To work out annual deductions using the Diminishing Value method, use the following calculation:
Base Value x Days Held/365 x 200% Effective Life
 
Note that the above calculations are based on assets bought after 10 May 2006. The ATO has a slightly different formula for assets purchased prior to this.
 
Prime Cost vs Diminishing Value: a working example
To demonstrate how these methods work out over time, we show each method calculated for the installation of carpet (which has an Effective Life of 10 years), at a cost of $1,000, below. These calculations assume the carpet is held for the full year in year 1.
 
Prime Cost method Diminishing Value method
$1,000 X 1 X 10%
= $100 per annum for 10 years
First year:
$1,000 X 1 X 20%
=$200 in the first year
 
Second year:
$800 X 1 X 20%
=$160 in the second year
 
Third year
=$640 X 1 X 20%
=$128 in the third year
  And so on.

Choosing a calculation method

It’s clear the outcomes of each calculation method are very different, and so the choice of calculation will come down to factors such as:
  • The length of time you wish to hold onto the property
  • Whether you intend to occupy the property as your primary place of residence in initial years or later years
  • Whether deductions on your assessable income are more valuable in the short term or the long term.
 
The Diminishing Value method tends to be the most popular since it can achieve higher short-term deductions, thus maximising the benefit where an investor sells a property before the Effective Life of Depreciating Assets has expired.
 
However there are circumstances where the Prime Cost method may be more beneficial, for example if you wish to minimise tax deductions in the first years of property ownership given your financial situation. A further example of where Diminishing Value may be better is if the property is initially used as your primary place of residence. In this instance you could not claim depreciation in the first years of asset ownership, and therefore it would be better to maximise deductions later in each asset’s Effective Life.
 
It is important to seek advice from a registered taxation agent on these issues. Once a method of calculation is used it must continue to be used for that asset’s Effective Life.
 
Depreciating Assets costing between $300 and $1,000: the low value pool
Low value pooling is used by the ATO to group and depreciate low value assets. Items costing between $300 and $1,000 fall into the low value pool and attract a higher depreciation rate. In addition, assets initially costing more than $1,000, but which decline in value to less than $1,000, can then also be placed in the low value pool. Property investors who place assets in the low value pool are able to claim them at a rate of 18.75 per cent in the year of purchase. From the second year onwards the remaining balance of the item
can be claimed at a rate of 37.5 per cent. The low value pool is only available where you use the Diminishing Value method to calculate the depreciation of investment property.
 
With low value pooling the ATO is essentially making the task of depreciating multiple, low value items easier. Once you group assets in the low value pool you no longer need to work out their decline in value separately – only one calculation for the pool is necessary.
 
The ATO specifies ‘low cost assets’ and ‘low value assets’ as eligible for the low value pool:
  • Low-cost assets: An asset with an opening value of less than $1,000 in the year of acquisition. Once you choose to create a low-value pool and allocate a low-cost asset to it, you must pool all other low-cost assets you start to hold in that income year and in later income years
  • Low-value assets: An asset that has a written down value of less than $1,000 – ie it costs more than $1,000 in the financial year of acquisition, however after the previous year (or years) of depreciation its value falls under $1,000. You can decide whether to allocate low-value assets to the pool on an asset-byasset basis. In other words, as assets depreciate and qualify, you can add them as required.

There are some specific rules about the operation of low value pools, so it is advisable to seek professional advice to ensure you remain on the right side of the law when it comes to the depreciation investment property offers.

Assets costing less than $300 – immediate write-off
Assets which cost $300 or less can be written off as an immediate deduction.
 
The ATO places limitations on where items are purchased as part of a ‘set’. The rules here can be a little subjective – the law includes terms such as whether items are ‘substantially identical’ – however if items are designed to be used together or marketed together, then they will likely form part of a set, and therefore the cumulative cost must be used.
 
An example is dining chairs. Two chairs, at a value of $120 each, can be depreciated immediately (total cost of $240). However, if four matching chairs are purchased – at a cost of $480 – then these chairs (as a ‘set’) instead could go into the low value pool and be depreciated over several years.
 
Where you hold assets jointly – for example if you invest in an apartment that is part of a complex – then the cost of the asset to you is generally your proportionate share. Therefore you may be able to immediately deduct certain shared assets even if the asset cost much more than $300. 
 
Using Depreciating Assets for private use
The decline in value of a Depreciating Asset starts when you first use it, or install it ready for use, for any purpose. This includes a private purpose. If you use an asset for private purposes and later put it in your investment property, you can still claim depreciation
but the decline in value begins from the start time of that asset – ie its purchase date. You would then work out deductions for the years you use it in the investment property.
 
Online tools and resources for calculating deductions
The ATO has a ‘Decline in value calculator’, which can be used to determine the Prime Cost and Diminishing Value methods for Depreciating Assets. The calculator is located at: http://www.ato.gov.au/Calculators-and-tools/Decline-in-value/
 
You may also want to refer to the ATO’s list of Depreciating Assets and their Effective Lives. This list includes items that qualify under the capital works allowance so you can easily distinguish the differences: http://www.ato.gov.au/General/Property/In-detail/Rental-properties/Rental-properties-2012-13/?page=21#Treatment_as_depreciating_assets_or_capital_works
 
Depreciation reports and the quantity surveyor
It is clear that depreciation of investment property is a complex topic. Yet if done correctly it can provide significant tax deductions to the investor. So how do you go about doing it accurately to take advantage of your full entitlements?
 
The ATO provides technical detail but that does not help the average investor who would need to take significant time learning the legislation and visiting their property to record the necessary information. Even then it can be next to impossible for an untrained person to capture all of the assets and correctly categorise them, identify additions to a property, or work out historical construction expenses. There is a large risk that significant deductions will be missed, or mistakes will be made that will require correction later on.
 
For example, some items can create confusion when it comes to categorising them into either a Division 43 or Division 40 deduction. Air conditioning units fall under Division 40, whereas ducting throughout a house for the same air conditioner would fall under Division 43. Identifying all of these distinctions amongst hundreds of assets can be challenging.
 
A quantity surveyor can provide you with a detailed depreciation report that will be valid for as long as your property still has depreciable value, ie for up to 40 years. Many people baulk at the cost of a depreciation report but some surveying companies actually guarantee two or three times the cost of the report in deductions, and a quantity surveyor’s fees are generally 100% deductible. Quantity surveyors are one of only a small group of industry professionals identified by the ATO to have the expertise to provide
services such as estimating historical construction expenses.
 
A good quantity surveyor will:
  • Visit the site and carry out a detailed inspection
  • Compile records and photographs for substantiation (if required) with the ATO
  • Examine plans and documents associated with the property.

A good quantity surveyor’s report should include:

  • Detailed inventory of all of your property’s Depreciating Assets together with Capital Works allowances
  • Calculations showing and comparing both valuation methods, enabling your accountant to choose the method best suited to your particular situation
  • Calculations taken pro-rata for the first year of ownership, so you are claiming your entitlement only and not any private use or use before you owned the property.
  • Investor Assist recommends and works with the following depreciation and quantity surveying specialists with offices in Perth:
  • BMT Tax Depreciation Quantity Surveyors - www.bmtqs.com.au
  • Deppro Depreciation Professionals - www.deppro.com.au

Tips and ideas to make the most of your investment property depreciation schedule

The rules about depreciation are complicated but this opens numerous opportunities for investors willing to learn. Following are a range of tips and ideas to help you get the most out of your depreciation deductions. 

You can get investment property depreciation deductions from all properties – old and new

New properties will generally achieve a greater rate and overall amount of depreciation because investors can achieve the maximum Capital Works Allowance, and make the most of low cost pools and immediate deductions for certain assets. However, even properties built prior to 1985 (when the Capital Works Allowance commenced) are worth depreciating.

It’s worth checking whether older properties have had renovations or additions as these may attract a Capital Works Allowance. An experienced quantity surveyor may be able to find a range of deductions. In addition, even if you need to renovate you may be able to claim residual investment property depreciation value in assets such as old blinds, carpets and cook tops as long as the property was built after 1985. This will give you immediate deductions before you even finish the new additions.

Portioning of Depreciating Assets in multi-unit developments

Remembering that items costing less than $300 can be written off your investment property depreciation schedule immediately, if you have invested in an apartment or unit complex portion falls under $300. Examples might include fire hose reels and intercoms.

Remember the low value pool category

Items costing between $300 and $1000 fall into the Low Value Pool category and attract a higher depreciation rate on your investment property depreciation schedule. As a practical example, if you are furnishing an investment property and are purchasing furniture, finding items less than $1,000 will help provide faster depreciation deductions. This could be vital if you have a short investment timeframe.

Furnishing a property generates higher depreciation of investment property… but remember what this means

It is clear that furnishing a rental property will generate much higher deductions for Depreciating Assets such as furniture. Some developers include packages with new properties (eg white goods and furniture) that can result in generous depreciation allowances for investors in the first year. This is certainly a point to consider if you are weighing up various apartment investment opportunities. However, remember that furniture suffers wear and tear, and if you are holding a property for the long term the advantages of depreciation deductions may be far outweighed by the cost of eventually replacing these assets.

New properties that are discounted can be great from a depreciation perspective

One point to remember about the Capital Works allowance is that the original construction cost must be used. This can provide advantages in a falling market where the investment property depreciation deduction relative to the purchase price increases.

Be careful with construction costs

We have noted cases where a builder quotes the cost of some assets (such as ovens) at wholesale price, rather than retail price. By using wholesale prices the investor will achieve a smaller depreciation deduction, and be worse off than they are entitled to. 

If you haven’t claimed depreciation, you could back claim

If you own an investment property but have not been claiming depreciation on investment property, you are allowed to amend up to two years’ of tax returns to do so. Your accountant will be able to arrange this for you.

Repairs, improvements and investment property depreciation

Investors can be confused by repairs and improvements, and depreciation of investment property adds another layer of complexity. A ‘repair’ is when you are making good or remedying a defect, damage or deterioration, such as replacing guttering. ‘Maintenance’ is any activity done to prevent deterioration, such as painting and oiling. As long as these activities are related to ‘general wear and tear’ due to renting out your property, they are deductible in the year performed. 

If it doesn’t relate to general wear and tear, or if what you are doing is an ‘improvement’ (ie where you are providing something ‘new’ or ‘going beyond just restoring the efficient functioning of the property’) then these become part of the Capital Works Allowance. 

This includes replacing capital equipment such as a complete fence or kitchen cupboards.

Sources

• Australian Taxation Office

• BMT Tax Depreciation Quantity Surveyors

DISCLAIMER: This information is of a general nature only and does not constitute professional advice. We strongly recommend that you seek your own professional advice in relation to your particular circumstance. Investor Assist Pty Ltd Builders Registration No. 13818.