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A lot of investors include tax depreciation among their primary considerations when buying properties, however, not all investors maximise their claims. What do you need to know when claiming tax deductions on your asset?
Essentially, depreciation is a tax deduction that you can claim when your asset’s value declines because of wear and tear. Depreciation allows you to pay less tax and increases your cash flow by reducing your taxable income.
According to BMT Tax Depreciation’s Bradley Beer: “When you buy a property and use it for investment, there will be wear and tear or [a] decline in values against your stove or your hot water service—your bricks and mortar, for that matter. The tax office allows us to make a tax deduction for those losses.”
“You think, ‘Hang on, I'm buying property for it to appreciate in value because I want to grow wealth, so what's this depreciation on property?’ But it's actually related to the building itself and the items in it. Those are wearing out.
“Even though your property is worth more, your carpets still wearing out over that time,” the quantity surveyor explained further.
Mr Beer encouraged investors to understand depreciation before buying a property because it can ultimately influence your cash flow.
With the help of professionals, he suggested calculating an estimate of how much the depreciation value on your property will be so you can gauge how your cash flow will turn out. However, he advised against picking an asset mainly for the tax deductions you can get.
At the end of the day, your primary consideration must be the growth drivers that will create wealth for you in the long term.
To come up with a good estimate of the depreciation value, you will need a comprehensive report of the claimable deductions on your property—a depreciation schedule.
This report is prepared by a quantity surveyor, who works hand-in-hand with the tax office.
Mr Beer explained: “Surveyors list the items and their value or cost, then the tax office tells them how long they should last or an effective life on these items.”
“The depreciation schedule is pretty much that—a list of items, a value against those items, how much life they’re expected to have and a projection of the numbers that tell you what to claim each year,” he added.
How often depreciation schedules are done is based on the preference of the investor, but the most important report is the first one, according to the quantity surveyor.
The first depreciation schedule contains a long-term projection—usually for decades—because there are usually only minor changes in the property within a shorter period. Unless you make a significant alteration on purpose. the depreciation value adheres to the projection, he said.
For the succeeding years, you can opt to work with your accountant to come up with the depreciation value of your asset based on the first report.
According to Mr Beer: “The premise of depreciation is there's a cost on an item when you acquire it and that is set at the time that you acquire that item. Once that's done, it has a depreciation rate applied to it.”
“So, if I told you what it was for the first year, you or your accountant can actually work it out for the second year. You don't need to come and see me again to do that because we project it for the life.
“The only thing that changes is, in around five years’ time, your stove could break down or something like that. Obviously, you'll need to get rid of that stove, which will have a scrapping value associated with it, and you put a new stove in and start depreciating the new stove,” he added.
Considering the importance of depreciation schedules, Mr Beer strongly encouraged getting a quantity surveyor to do it for you.
Quantity surveyors are trained to measure and estimate construction costs, apply all the necessary tax rules on them and work out how you can get as many deductions on your property as you can.
Their specialisation makes them a reliable source for the Australian Tax Office (ATO). If you choose to do-it-yourself, the ATO will most likely question the accuracy of the data you provide, according to Mr Beer.
He said: “The reason you don't do this yourself is the tax office says they want someone who knows about construction costs involved in this process. From a compliance point of view, the tax office can say, ‘Where'd you come up with your costs?’ ”
After the first depreciation schedule is done, you can start consulting your accountant for the succeeding reports. Basically, come tax time, your accountant can suggest to either work it out with you or contact a quantity surveyor once again.
According to Mr Beer, a good accountant will understand that they are not specialised to come up with such a report, especially if it needs an extensive update.
The quantity surveyor said: “A proactive accountant doing the right thing by your property would understand that they're not a quantity surveyor that estimates construction costs—if they come up with some numbers and they get challenged, they'll have nothing to rest on.”
The ideal scenario, according to him, would be having your accountant and quantity surveyor work hand-in-hand to marry the numbers and the set of tax rules applicable to project a good estimate of the depreciation value on your property.
Tune in to Bradley Beer’s episode on The Smart Property Investment Show to know more about the concept of depreciation and how it can influence the growth of your portfolio.