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I think most investors will know of the word depreciation. They would have come across it somewhere, but often it’s a secondary, if not a third or fourth, consideration when it comes to managing a portfolio.
I’ve done this myself in the past, but it shouldn’t be ignored because it’s very important.
So, what is it, and why is it significant?
Recently, I had CEO of BMT Depreciation Brad Beer on the podcast, and he had a great way of explaining it in simple terms. I’ve known Brad for a number of years now. We see each other at property shows all over the joint and often get together just to talk property investment. (Sometimes, over a good bottle of red, which I do like.)
Anyway, I digress. Back to Brad. He said that the best way to understand it is to think of a new car. It loses value as soon as you drive it out the showroom door. Depreciation, when it relates to property, is a similar concept. You buy a property, and if you use it for investment, this wear and tear means a decline in value against items like the stove, the hot water service, or even the bricks and mortar, for that matter.
This stuff is important for investors because the tax office allows us to make a tax deduction for those losses. This is where it gets a little counterintuitive, but Brad explains it well again. It’s a little harder to understand on your property because you think — hang on, I’m buying property for it to appreciate in value because I want to grow my wealth, so what’s this depreciation on property? But it’s actually related to the building itself and the items in it. Those actually are wearing out because even though your property is worth more, your carpets are still wearing out over that time.
So, it’s a tool for investors to use when they do their tax return. They can actually say to the tax office — here’s my asset; this is the stuff going down in value and therefore there should be some tax consequence associated with that. That is pretty much what it is, but there is also a bit more to it than that.
Again, Brad explains it well. The fundamentals of investing in property and why you do that are about wealth creation, and there are drivers for value that are important for that, and then there’s a cash flow output to that. Depreciation is one of those cash flow elements that, in crunching all your numbers before you buy that property, you should have an understanding of.
But you don’t buy something for tax deductions; you buy it to create wealth. When you do a tax return, there’s a certain number attached to this depreciation. Now before you buy, you want some sort of estimate of how much that number should be so you know what your cash flow is going to look like, but you make these deductions generally when you do a tax return.
And that’s kinda where people like Brad come into the scenario. They calculate those numbers. Basically, in the form of a depreciation schedule. It’s a list of all the items and what they are and the speed at which they go down in value.
The important part is really a value or cost on those items, which is what the quantity surveyor does. And then, the tax office determines how long they should last, or an effective life on these items, projects out the numbers and tells us what to claim each year.