The power of depreciation: maximising your property investment returns

Promoted by Capital Claims Tax Depreciation Quantity Surveyors

One such tool, often underutilised, is depreciation. As a quantity surveyor, I have seen firsthand how depreciation can significantly enhance the financial performance of investment properties. This article delves into the benefits of depreciation, particularly highlighting its role as one of the largest tax deductions claimable by property investors.

We will also explore how depreciation allows an investment property to be both negatively geared and cash flow positive simultaneously, a concept that has gained attention amidst recent discussions around negative gearing in the media.

Understanding depreciation

Depreciation is the process of allocating the cost of a tangible asset over its useful life. For property investors, this means you can claim a tax deduction for the wear and tear on your investment property. The Australian Taxation Office (ATO) allows investors to claim depreciation on both the building structure (Capital Works Deduction) and the plant and equipment (Depreciating Assets).

The two types of depreciation

1. Capital Works Deduction (Division 43): This refers to the deduction for the building's structure and any permanent fixtures. Residential properties built after 16 September 1987 are eligible for capital works deductions at a rate of 2.5% per year for 40 years.
2. Plant and Equipment (Division 40): This includes removable items within the property such as appliances, carpets, and blinds. These items have varying effective lives and depreciation rates.

The financial impact of depreciation

Depreciation is one of the largest tax deductions available to property investors. By claiming depreciation, investors can reduce their taxable income, thereby lowering their tax liability. This can result in significant cash flow benefits, making it easier to manage the costs associated with owning an investment property.

For example, consider an investor who owns a property with a building value of $250,000 and plant and equipment valued at $50,000. Assuming the property was built after 1987, the investor can claim $5,000 per year in capital works deductions (2.5% of $250,000) and additional deductions for the plant and equipment, which could amount to several thousand dollars annually. This reduces the investor's taxable income, potentially saving thousands of dollars in tax each year.

Negative gearing and cash flow positive properties

Negative gearing occurs when the costs of owning a rental property exceed the rental income it generates. These costs can include mortgage interest, maintenance, and other expenses. The shortfall can be offset against other income, reducing the investor's overall tax liability.

However, a property can be both negatively geared and cash flow positive at the same time, thanks to depreciation. Here's how:

1. Negative Gearing: Let's say an investor's property generates $20,000 in rental income annually, but the total expenses (including mortgage interest, maintenance, and other costs) amount to $25,000. This results in a $5,000 loss, which can be offset against the investor's other income, reducing their taxable income.
2. Depreciation: Now, if the investor claims $10,000 in depreciation deductions, their taxable income is further reduced by this amount. While the depreciation is a non-cash deduction (meaning it doesn't involve an actual outlay of cash), it still reduces the investor's taxable income.
3. Cash Flow Positive: Despite the property being negatively geared (with a $5,000 loss), the investor's cash flow can be positive. This is because the depreciation deduction increases the tax refund, providing additional cash flow. For instance, if the investor's marginal tax rate is 37%, the additional $10,000 depreciation deduction could result in an improvement to the tax refund of $3,700. This refund can offset the $5,000 loss, resulting in a net positive cash flow of $550.

Explanation

Without depreciation

• The property generates $20,000 in rental income and incurs $25,000 in expenses, resulting in a net rental loss of $5,000.
• This $5,000 loss reduces the investor's taxable income, leading to a tax reduction of $1,850 (assuming a 37% tax rate).
• The net cash flow is -$3,150, indicating a negative cash flow.

With depreciation

• In addition to the $5,000 net rental loss, the investor claims an additional $10,000 in depreciation deductions.
• This increases the total reduction in taxable income to $15,000.
• The tax refund increases to $5,550 (37% of $15,000).
• The net cash flow becomes $550, indicating a positive cash flow.

Recent discussions around negative gearing

Negative gearing has been a hot topic in the media, with debates about its impact on housing affordability and the broader economy. Some argue that negative gearing benefits wealthier investors and drives up property prices, making it harder for first-time buyers to enter the market. Others contend that it encourages investment in housing, increasing the supply of rental properties and helping to keep rents affordable.

In this context, understanding the role of depreciation is crucial. Depreciation not only enhances the financial viability of property investments but also plays a key role in the negative gearing equation. By maximising depreciation deductions, investors can improve their cash flow and overall return on investment, even in a negatively geared scenario.

Maximising depreciation benefits

To fully leverage the benefits of depreciation, it's essential to obtain a professional depreciation schedule. A quantity surveyor can prepare a detailed report outlining the depreciation deductions available for your property. This report can be used to substantiate your claims with the ATO and ensure you're maximising your tax benefits.

Here are some tips to maximise your depreciation benefits:

1. Engage a Quantity Surveyor:  A qualified quantity surveyor can identify all depreciable items within your property and prepare a comprehensive depreciation schedule. Estimates of construction costs and asset values are prepared, and forecasts of the deductions are calculated. This ensures you're claiming the maximum deductions available.
2. Keep Detailed Records: Maintain accurate records of all expenses related to your investment property, including purchase documents, receipts for improvements, and additional works including asset replacement. This information is crucial for preparing an accurate depreciation schedule.
3. Review Your Schedule Annually: Depreciation schedules should be reviewed annually to account for any changes to the property, such as renovations or new purchases. There may be an ability to claim immediate deductions for works that have been removed and scrapped during this process. This ensures your deductions remain up-to-date and accurate.
4. Consider Timing: The timing of property purchases and improvements can impact your depreciation deductions. For example, purchasing a property towards the end of the financial year may allow you to claim a full year's worth of depreciation in the remaining period of the year for low cost and low value assets. Back claiming for previous years of depreciation can also provide a bumper refund where depreciation was previously not applied to annual tax returns.

Conclusion

Depreciation is a powerful tool for property investors, offering substantial tax benefits and enhancing cash flow. By understanding and leveraging depreciation, investors can improve the financial performance of their properties, even in a negatively geared scenario. As discussions around negative gearing continue in the media, it's more important than ever for investors to be aware of the benefits of depreciation and how it can impact their investment strategy.

Engaging a professional quantity surveyor to prepare a detailed depreciation schedule is a crucial step in maximising these benefits. With the right approach, depreciation can help you achieve a more profitable and sustainable property investment portfolio.

For more information or to schedule a consultation, please visit https://www.capitalclaims.com.au

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