What you don’t know can hurt you
Written by Terry Taylor – Specific Property
Seven-thirty PM on the 9th of May, 2017 was an important time and date in most property investors lives. What occurred at that time was an announcement in the Federal budget by the Australian Government of changes to legislation relating to depreciation benefits that residential property investors can claim.
Previous to this time there were two types of depreciation, known as non-cash deductions, that every residential property investor could take advantage of when preparing their tax returns. The intent of these deductions has always been to assist an investor build a portfolio of assets to provide for their income in later life and retirement. To allow them to do this, the Government provided incentives to reduce the holding cost of those assets, whilst the investor was able to benefit from the capital growth of the property, increasing rental returns over time and of course to pay the property down. The Government’s intention with this measure is to reduce the need to provide support for those people later on in retirement.
There are two types of depreciation allowable to a property investor. Firstly, the division 43 Capital works deduction, which allows an investor to claim 2.5% of the original building cost of the property they are buying each year for 40 years. An example of this would be where the bricks and mortar construction cost of the property was say $400,000, an investor would be able to claim 2.5% or 1/40th of this amount in other words, $10,000, per year, each year for forty years. They call this a non-cash deduction because you haven’t actually paid that money and the way this works is that $10,000 per year would be deducted from your pre-tax income meaning that you would pay your income tax on a lower amount. The result is that you pay less income tax, thus saving you money.
It should be pointed out and we find that most people are not aware that the Government does not give you this deduction for nothing, they are just delaying the time that you will have to pay for it. To do this each time you or your accountant claims this non-cash deduction, the capital base of the property is reduced by the same amount and effectively increasing the amount of capital gains tax you will have to pay when the property is sold. Of course, the way things stand, investors who own properties for more than 12 months are given a 50% capital gains tax concession on the profit they make. In simple terms this would mean if you made $200,000 profit, you would only pay tax on $100,000 of that profit, a huge benefit to the investor. So the government doesn’t take away the full benefit of claiming the depreciation benefit.
You also have the additional benefit of being able to time the sale of your property to coincide with when your income is lower/lowest and therefore paying a lower percentage of overall tax. Because any capital gains tax that you pay is calculated at the marginal level of tax you are currently paying.
The 2017 budget changes do not affect investors receiving this division 43 capital works deductions, so you will be able to go on claiming those deductions as previously the case.
The big change to the depreciation rules is around the second type of depreciation allowance available to property investors, the Division 40 plant and equipment depreciation. Plant and equipment assets are those deemed to be easily removable or mechanical items found within an investment property. They can include items such as air-conditioners, dishwashers, ovens, garage doors, carpet and blinds. Prior to the legislative changes all property investors could reduce their taxable income by a percentage of the plant and equipment’s purchase price over the effective life of the asset. The deductions available to investors under Division 40 were larger in the earlier stages of the assets life and diminished over the assets effective life until either no longer owned or fully depreciated.
Division 40 allowances can be calculated using either a diminishing value or prime cost method where the assets are deducted over a 15 year period with the highest proportion of deductions in the first 1-5 years, especially in the diminishing value method. As an example the following table has been produced by BMT Tax Depreciation and shows the different methods and values of calculation for an original Division 40 cost of $26,787.
So looking at our earlier example, a property investor would be able to claim the $10,000 per year for the division 43 allowance plus the applicable division 40 allowance which might be an additional $5,302 for the financial year 2018. This would be a total of $15,302 to be deducted when calculating income tax from their taxable income. Both the division 40 and 43 depreciation allowances were available to all property investors prior to 7:30pm 9th of May 2017.
However since the changes to legislation were passed on the 15th of November, those property investors who exchanged contracts after 7:30pm on the 9th of May 2017 and who purchased a second-hand property are no longer entitled to claim any division 40 allowances. Please note it is the date of signing the contract and not the settlement date of the property that is relevant with these new property depreciation changes.
Effectively what that means is that any property investor who purchases a second-hand property from now on will not be entitled to the division 40 deductions on the property purchase. If the property investor however purchases new or replacement plant and equipment, they are then entitled to claim the division 40 depreciation solely on those assets they actually add to the property, in other words their own new expenditure.
The key thing to note is that those who purchase a new property will still be able to depreciate plant and equipment assets as they had previously. There is NO change for property investors who purchase a brand new property.