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Here is our basic guide on how rental property depreciation works.
Depreciation is one of the best tax benefits a real estate investor is entitled to.
Anyone who buys a property for income-producing purposes (e.g. rental property) is entitled to depreciate the building and the items within it against their assessable income.
In fact, seasoned investors typically factor depreciation into account before purchasing their next real estate investment.
However, others are none the wiser. This means that every year, thousands of dollars go unclaimed.
Custodian CEO and 7 Steps to Wealth author John Fitzgerald has urged property investors to learn how to make the most of the tax deductions available to them.
“I’m continually surprised by the number of investment property owners who don’t even claim depreciation on their asset. These deductions can be quite significant, I’m talking in the thousands of dollars, particularly when you buy a brand-new investment property.”
If you haven’t been claiming depreciation deductions on your rental property, the best time to learn is now. So, here is our basic guide on how rental property depreciation works.
What is rental property depreciation?
For starters, let’s understand what depreciation is. Simply put, depreciation is a financial term used to describe the decrease in value of an asset over time due to wear and tear.
This also applies to investment properties. As a property gets older, the building’s structure and the assets within it wear out. In other words, they depreciate.
So, what is rental property depreciation? Property depreciation refers to a tax break that allows investors to offset their investment property’s decline in value from their taxable income.
In Australia, investors can claim tax deductions on both the decline in value of the building’s structure and items considered permanently fixed to the property and the decline in value of plant and equipment assets found within the real estate.
Not only does it help investors pay less tax, but it is also a “non-cash deduction”. This means that you don’t have to pay for it on an ongoing basis because the deductions are built into the purchase price of your property.
What rental property depreciation expenses can you claim?
Australian law allows investors to claim tax deductions on the depreciation of rental property assets under two categories: capital works and capital allowances (e.g. plant and equipment assets).
Capital works deductions refer to the claims an investor can make for the wear and tear that occurs to the structure of the rental property.
Capital work assets are any fixed items like the roof, walls, doors and kitchen cupboards. Examples of capital work assets that are eligible tax-deductible depreciation expenses include:
Owners of residential properties that commenced construction after 15 September 1987 can claim capital works deductions, which can be claimed at a rate of 2.5 per cent per year for forty years.
If your rental property was constructed before this date, you should still inquire about the depreciation deduction available as often these buildings have undergone some form of renovation, which can generate capital works deductions.
Meanwhile, if you have purchased a rental property that was significantly (not cosmetically) renovated by the previous owner before the sale, you are also entitled to claim the associated capital works deductions within the 40-year time period.
In this scenario, it’s advised to enlist the services of a quantity surveyor who will be able to assess and identify renovations that are not on a surface level, including new plumbing or updated electrical wiring.
Additionally, if you ever eventually remove any capital works assets within the 40-year time period, you can claim any depreciation that was not deducted in the year the asset is removed in a process called “scrapping”.
Plant and equipment assets refer to the removable fixtures and fittings that are found within a rental property. Depreciation deductions for these assets are calculated based on their individual effective life as set by the ATO.
For rental property investors, this might include light fittings, stoves, carpets, air-conditioning unit, or a garbage bin.
If you’re unsure of what items you should include, the ATO lists all items you can claim — and for how long. The ATO provides a comprehensive table of the estimated effective life of a wide range of potential rental property plant and equipment assets.
If you want to make sure you don’t miss out on anything, you can engage the services of a quantity surveyor to evaluate your property’s plant and equipment assets to provide you with a depreciation schedule.
You can also calculate the determinable useful life of your assets yourself and depreciate them accordingly. But remember that you must be able to justify your calculations to the ATO.
There are two methods you can use to calculate the amount of depreciation you can claim on rental property plant and equipment assets:
The depreciation of the asset would be spread evenly over its effective life. For example, a $1,500 asset with a determined useful life of five years would be depreciated at $300 per year.
The depreciation each year is calculated on the depreciated (i.e. diminished) value of the asset each year of its useful life. That means the depreciation tax deduction is highest in the early years of the asset’s life, rather than being evenly spread like it is with the prime cost method.
The full depreciation on rental property plant and equipment assets costing $300 or less can be depreciated in their first year of use. However, plant and equipment assets costing over $300 must be depreciated over their estimated useful life.
What are the 2017 legislation changes for depreciation? Why does it matter?
Note that from 1 July 2017 (as announced in the May 2017 budget), real estate investors can only claim tax depreciation for plant and equipment if you actually bought it yourself or it was included in the new property.
You also cannot claim depreciation on an asset that you buy if you are living in your rental property while you are renovating it.
On the upside, you can still claim depreciation for any brand-new plant and equipment assets you purchase and install in the property once it is producing income.
For example, if you purchase a new hot water system while your property is being leased, you are entitled to claim depreciation for this asset.
It’s recommended for investors to only buy new plant and equipment assets if they are not living in the property and it is either tenanted or available for rent.
What records should you keep for claiming depreciation?
Keeping track of the needed documents will help make it easier for you to claim depreciation when tax time comes.
For capital works assets, the following expense records over the 40-year eligibility period should be kept:
All other rental property depreciation expense records, such as receipts for plant and equipment assets, should be kept for the estimated life of the asset and then for another five years after you file your tax returns.
How can you claim depreciation on my rental property?
The most convenient way to claim depreciation on your rental property is to get a tax depreciation schedule prepared for the property.
A rental property depreciation schedule is a document that provides you and your accountant with the proper information regarding depreciation claims on your property. Simply put, the depreciation schedule contains relevant data regarding the compensation for wear and tear of the building.
To get a tax depreciation schedule, all property investors need to do is arrange for a qualified quantity surveyor to inspect their home. A trained quantity surveyor will ensure all depreciable items are noted and photographed. This will ensure that you won’t miss out on any deductions. The documentation can then be used as evidence in the event of an audit.
How much will a depreciation schedule cost?
The cost of preparing a tax depreciation schedule depends on several factors, including the type of investment property you’ve purchased, its location and size.
Most of the time, surveyors offer a money-back guarantee to save you twice your fee in the first year, or they give you the report for free.
To further sweeten the deal, quantity surveyor fees are 100 per cent tax-deductible. So you have absolutely nothing to lose – and many tax deductions to gain.
It’s important to claim all eligible tax deductions in order to maximise the return on your investment property. Make sure to visit Smart Property Investment’s Tax and Legal page for the latest updates, insights, and tips on tax and legal strategies for investors.
Real estate is a type of real property that refers to any land and its permanent improvement or structures that come with it, whether natural or man-made.