Wear and tear are an inevitable part of owning an investment property. But did you know you might be able to use your rental property’s decline in value as a way to save on your next tax return?
Investment property depreciation can be your ticket to significant savings as an investor. You can claim thousands of dollars in tax deductions by knowing what does and doesn’t fall under this tax concession category.
If you’re looking for practical, legal ways to increase your returns and lower your expenses as a property investor - keep reading! Discover what investment property depreciation is, how it works, how much depreciation you might be able to claim, and a stack of helpful tips to calculate depreciation on your rental property.
What is investment property depreciation?
Let’s start with the basics. Investment property depreciation is a tax break that can allow investors to claim back some of their investment property’s decline in value on their next tax return.
How? Well, investors can actually claim tax deductions on two areas of their rental property:
- The decline in value of the building’s structure and the property’s ‘permanent fixtures’ (a.k.a. items that are permanently fixed to the rental property)
- The decline in value of ‘plant and equipment assets’ inside the rental property (think things like ovens, dishwashers, curtains and carpets)
As an investor, there are a couple of interesting things to note about investment property deductions. First up, claiming these items can potentially help lower your tax bill on your next income tax return.
Best of all, these expenses are known as “non-cash deductions”. In short, it means that you don’t have to pay for these expenses on an ongoing basis. Instead, you can claim these depreciating assets at the time of purchase and these deductions are built into the sale property’s sale price.
In order to claim these deductions, you’ll need to work with a quantity surveyor who will be able to prepare a document known as a tax depreciation schedule for a rental property. This schedule sets out all of the investment property depreciation assets you’re planning to claim a deduction on.
The cost of preparing this document depends on a stack of factors, from the type of property you’re purchasing to the size and location of your rental property.
How does rental property depreciation work?
Now that we’ve introduced the concept of investment property depreciation, let’s take a deeper dive into exactly how this process works as a rental property owner.
Preparing a tax depreciation schedule for rental properties
First up, the ATO requires all residential properties built after 1985 to prepare their depreciation schedule for any rentals by a quantity surveyor. They’ll be able to inspect your property, review and record any relevant items and provide an estimate of the construction and asset costs you can expect to claim.
As we mentioned, this depreciation schedule will be broken down into two main categories: Capital Works Allowance vs Plants and Equipment. Working with an experienced quantity surveyor can ensure you’re capitalising on every possible tax deduction and leaving no money on the table.
In general terms, it should cost between $400 and $750 for this report to be created. Then, you can provide this document to your accountant to help you claim your investment property’s depreciation as deductions on your next income tax return.
Claiming deductions for rental property depreciation
So, what kind of items and expenses can you expect to claim a deduction for when it comes to investment property depreciation?
- New assets: if you add new fixtures to an investment property, you can claim their decline in value (as long as the property’s old owner hasn't previously claimed them).
- Substantial renovations: if you decide to replace your rental property’s foundation, external walls, interior supporting walls, floors, roof or staircases, you may be able to claim these significant renovations.
- Second-hand depreciating assets: if you’re using a property for income-generating purposes (like leasing it to tenants), you may be able to deduct certain types of second-hand assets (as long as the asset was purchased and installed by certain company dates).
Plus, you need to factor in the significant changes to investment property depreciation that came into effect in 2017.
As an example, suppose you purchased a second-hand residential property that settled on 10 May 2017 or later. You can no longer claim depreciation of “previously used” assets (such as ovens, dishwashers, lights, air-conditioners, TVs, carpets, lounge suites and blinds).
However, you can still claim the “Building Allowances” category of deductions. You should still engage a quantity surveyor to calculate your potential deductions for things like the declining value of brickwork and concrete.
The good news is that if you purchase a brand new rental property, you can claim total investment property depreciation on both Plant and Equipment as well as Building Allowances.
How much can you claim in rental property depreciation?
The amount you can claim in investment property depreciation depends on the age of your rental property, whether you’ve secured a new or established rental property and what your quantity surveyor believes your property’s building and assets to be worth.
A practical way to estimate how much you may be able to claim is to use a free online property depreciation calculator. By entering your investment property’s purchase price, purchase date, build year, property types, the standard of finish and nearest city, you can score a snapshot of your potential tax savings.
The costs of your depreciating assets will determine when you can make a deduction:
- If your depreciating assets cost more than $300: you can claim deductions for the decline in value of their useable lifetime.
- If your depreciating assets cost less than $300: you can claim an immediate, full deduction for this expense in the income year you used the asset for a taxable purpose (like setting up your rental property).
How far back can you claim depreciation on a rental property?
It’s also worth knowing when is the best time to set up your depreciation schedule. Ideally, you should get your depreciation schedule created as soon as possible after settlement. However, you can backdate this schedule by up to two years if needed.
It’s also a smart move to get this inspection and schedule prepared prior to leasing out your rental property to avoid any new wear and tear being done to your property.
Plus, if you conduct any significant renovations or replace any major assets, you should get your schedule updated.
Can you claim depreciation on a rental property that is not available for rent?
The big thing to remember about investment property depreciation is this: you can only make claims for the period when your property is genuinely available for rent or rented out.
So, if your property is vacant or you’re leasing it to a friend or family member (at a heavily discount rate or even free of charge), you can’t make any claims during this time.
How do you calculate depreciation on an investment property?
Now, the bit you’ve all been waiting for: how do you actually go about calculating investment property depreciation?
These are two key methods of calculating these tax deductions: prime cost vs diminishing value method. Let’s run you through how to calculate each method:
- Prime cost method: this method helps you claim lower, but more consistent depreciating amounts each year. It involves claiming the decline in value each year as a uniform amount of the asset’s original value over its effective lifetime.
Here’s the formula you would use: asset’s cost x (days held ÷ 365) x (100% ÷ asset’s effective life)
- Diminishing value method: this method allows you to claim higher deductions in the earlier years of your asset’s life. To do so, you’ll be claiming the decline in value each year as a constant proportion of the asset’s remaining value.
Here’s the formula you would use: asset's cost × (days held ÷ 365) × (100% ÷ asset's effective life)
Now, let’s compare these methods to see which one will deliver a stronger return for you as an investor.
- Say you bought a new hot water system for your rental property for $1,500, with an effective life of five years.
- Under the diminished value method, here’s what you’d end up with: 1,500 × (366 ÷ 365) × (200% ÷ 5) = a $602 decline in value.
- Under the prime cost method, here’s what you’d end up with: $1,500 × (366 ÷ 365) × (100% ÷ 5) = a $301 decline in value.
That means you’d score a higher deduction in the first year with the diminished value method. However, if you’re looking for lower but more consistent deductions, you’d be best placed to use the prime cost method instead.
What are the benefits of depreciation for investors?
As an investor, the most significant benefit of investment property depreciation is its capacity to help you save big on your next (and future) income tax returns.
Here are a few reasons why you need to be harnessing the power of a depreciation schedule as a rental property owner:
- You can reduce your taxable income: investment property depreciation means you can claim the wear and tear and decline in value of your rental property as a tax deduction. With a proper schedule in place, you can reduce the tax you need to pay.
- You can claim legal tax deductions for your investment property: using a depreciation schedule is the only legal way to claim the decline in value of your rental property’s structure and allows you to maximise your potential savings to safeguard your rental returns.
- You can pay less tax, even for a renovated property: by working with a quantity surveyor, you can make the most of your potential tax savings from investment property depreciation (even if the property’s previous owner has renovated the property).
Understanding how investment property depreciation works and what you can claim can help you save potentially thousands of dollars in tax. The key is to work with a professional quantity surveyor who can help you maximise your savings and ensure you’re making these deductions in a compliant and legal way.
The more you save in tax, the more money you have to play with to grow your investment property portfolio and even tap into the equity in your property to secure your next rental property.
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