How does depreciation work with an investment property?

Last Updated 4 December 2014

What is depreciation?

Depreciation represents a reduction in the value of an asset due to usage over time. So if you buy a brand new investment property while the value of the land may increase and your property’s total value may increase over time some of the building features or fixtures in the property will decline in value. One way the ATO will allow you to account for this is by claiming a tax deduction for the depreciation each year. There are two main types of depreciation you can claim each year for your investment property on your tax return.

  1. Construction Costs
  2. Fit-Out Costs

Construction Costs

Also known as building & construction cost. For rental properties purchased after Sep 15 1987 you can claim 2.5% of the construction costs each year over 40 years from the date the construction commenced.

How does claiming construction cost depreciation affect capital gains tax?

Well if you are going to claim construction costs as a tax deduction each year the ATO would not like you to leave the cost base of the property the same as what you bought it for. Construction costs are classified as ‘Capital Works Deductions’ by the ATO and so reduce the cost base of your property. The ATO wants you to reduce your cost base by the amount of any of these ‘capital works deductions’ you have made. So you have to reduce the properties cost base by the amount of depreciation you have claimed. So it kind of works in a sense that claiming depreciation will reduce your taxable income now but lead to an increased capital gain later.

Fit-Out

These are items such as fridges, curtains, TVs etc. These are deductible each year. The deduction can be calculated using 2 methods:

  1. Prime Cost Method
  2. Diminishing Value Method

Prime Cost Method

This will lead to an equal deduction in each year. The formula used to calculate the deduction is: Deduction = Fit-out Cost x (100% / Asset's Effective Life) An asset’s effective life is how long it can be used for by the property for a taxable purpose.

Diminishing Value Method

This method will lead to larger depreciation claims in earlier years and smaller depreciation claims in later years when compared to the prime cost method. Deduction = base value x (days held / 365) x (200% / asset’s effective life) The base value is the fit-out value at the beginning of the year. So the base value will change each year due to adjustments to account for last year’s depreciation.

A simple example of the two methods available

If for example you purchased $2,000 air conditioning system (with a useful life of five years) for your investment unit on 1 July 2012. The following calculations could apply:

Calculating the depreciation rate to be claimed annually:

Prime Cost Method: 100%/5 = 20%

Diminishing Value Method: 150%/5= 30%

Table 1.1

Amount claimed in:

Prime Cost

Diminishing Value

Year 1

$400

$600

Year 2

$400

$420

Year 3

$400

$294

Year 4

$400

$205

Year 5

$400

$144

(The second year of depreciation under diminishing value method would be calculated as ($2,000 – 600 = $1400. Then $1400 x 30% = $420 and so on for year after)

Editors note: Notice that under the diminishing value method the there is still some value at the end of the assets useful life which can be further depreciated in later years. With the prime cost method the asset is depreciated in full at the end of its working life.

In my experience most professional investors in the higher tax bracket tend to use the diminishing value method and claim much larger amounts of depreciation in the earlier years of the life of the assets. This has a significant impact on the net cash flows after tax especially if you are negative gearing. For example at the highest tax bracket you would get 46.5% back in tax for each amount of depreciation, the effect is a reduction in your taxable income and a potential tax refund.

How to maximise your depreciation allowance

Typically new property has a lot more depreciation allowance than an older pre-owned property. If you are considering buying a brand new property to maximise depreciation make sure you read the guide on buying off the plan property. Also renovating an older property can increase the amount of depreciation available to an investor as there they are adding capital value to the property. For example adding a new kitchen and bathroom can increase the value of the property plus also increase the amount of rent a tenant will pay.  In either case additional capital is typically required depending on the kind of property and renovations required.

Is depreciation a legal tax deduction?

To make sure the depreciation deductions are legitimate for tax purposes, get a professional depreciation report to help you maximise the allowable depreciable amount on capital works and plant and equipment, the service of a quantity surveyor can help you with this. Depreciation reports can be ordered in Sydney, Melbourne, Brisbane and all other cities in Austrailia through a property valuation company such as BMT, Washington Brown and many others. This report is evidence of how you came to calculate the depreciation deductions.

Read more about property investing by going to our property guides here.

Calculate your investment property tax savings from claiming depreciation

The Investment Calculator will show you everything you want to know about investing your money in up to 10 investment properties, shares, super and a family home all for 2 investors over 30 years. For an example of what a property investment can cost watch this video.

The Investment Calculator assumes that most of fixtures and fittings will be written off in the first five years at a standard even rate of 20% (i.e the prime cost method).  Although there may be different life spans for each fixture and fitting (plant and equipment), the calculator uses an average to smooth out the total depreciation one would claim based on the initial costs and the time at which the assets were used from. To use the calculator you can download it as a free trial here.

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