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Property investors – You should budget for this!

How proposed changes in the latest Federal Government Budget are going to impact on property investors   

In the last Federal government budget some changes were announced that are likely to have a significant impact on many residential property investors and in particular if you have chosen your property poorly. More about that later in this article.  

The government announced that from the 1st of July 2017, plant and equipment depreciation deductions Division 40, will be limited to expenses actually incurred by real estate property investors.  

NOTE: Legislation is pending in the Federal Parliament with public feedback sought until 10th August,2017

Based on the new proposed changes investors who purchase plant and equipment for their residential property investment after 9 May 2017 will still be able to claim a deduction over the effective life of the asset.  Property investors however will be unable to claim deductions for plant and equipment purchased by a previous owner of the property. That is you will not be able to claim deductions on the existing plant and equipment if you buy an investment property that is not brand new. If you are the second or a subsequent owner of the property then you will only be able to claim on those items you actually buy yourself.

So what does this actually mean? Why is the Government doing this? And lastly and most importantly what will this mean for you as an investor?

There are two types of depreciation generally claimed on a residential property investment. They are division 40 and 43 allowances and they are called non-cash deductions because rather than claiming an expense that you have paid the cash for, these claimable benefits to an investor are not for actual expenses that you have incurred. Rather they are deductions you can claim, based on the depreciating value of the asset, against your income earned in a financial year. 

It should be noted that these deductions claimed as part of the expense of holding the property, will reduce the cost base of the property and may lead to a larger capital gains tax obligation when you eventually sell. The point is that these depreciation benefits reduce the current holding cost (out of pocket expenses) of the property.

The Division 43 Construction cost allowance, provides a deduction offset against an investors taxable income of 2.5% per year for 40 years and this is based on the original construction cost (bricks and mortar) of the asset. There is no change to the deductions available under this particular cost allowance for property investors.

The second depreciation benefit, the Division 40 allowance, and the one that will be affected by the proposed changes allows for a depreciation benefit on the original cost of plant and equipment. This relates to plant and equipment items, usually mechanical fixtures or those items that can be ‘easily’ removed from a property such as light fittings, carpets, dishwashers, ceiling fans, etc.  

The Division 40 depreciation allowance is not a fixed annual amount as is the Division 43 allowance, it is an allowance based on the effective life of the asset which is to be depreciated.  In other words, if a dishwasher for example was expected to last for 10 years, that particular asset, could be depreciated, (written-off to no value), over that 10 year period. 

So now we have explained how these depreciation allowances work, If you have previously purchased a residential investment property and it was brand new when you bought it, then you can relax. Previous taxation arrangements will be grandfathered, and what that means is that any depreciation benefits that existed, prior to the changes in the budget which take effect from the 1st July, 2017, will stay the same for you into the future. You will still be able to claim the two depreciation benefits, division 40 and 43 against your taxable income each financial year. 

If however you buy a residential property as an investment and you are not the first purchaser of that property then the holding cost of that investment will now be increased. What this means is that unless you have purchased a brand new property you will only be entitled to claim the construction cost -division 43 allowances as an offset against your taxable income.

Prior to the budget changes and when combined the Division 40 and 43 allowances, gave an investor enhanced benefits which helped to reduce the cost of holding the property and allowed time for the property to gradually grow in value and for rents to rise.  That of course is the object of investing in property in the first place.

So why is the government making these changes to the way we can claim some of the expenses?  There has been an enormous amount of press, most of it negative, about the prices of property and housing affordability, and how investors are instrumental in locking out many first home buyers from the market. The government obviously thinks that this is what is happening in the market today.

We, by the way don’t agree with this assumption. We think most people are having trouble entering the market because of the market they want to be in, rather than buying something they can afford to be in and gradually trading up as their financial capacity would allow. 

Many first home buyers want to start where their parents are finishing.  Of course this is not possible, nor was it ever possible for the great majority of property purchasers.  The government in making these changes is hoping to slow down the effect that they think residential property investors are having on the owner occupier market. 

We think these changes will reduce demand for property by investors, which is the intent of the budget changes but we think that this will also lead to a reduction in the supply of more property to the market.

If we are correct then in time a shortage of property will emerge which will benefit all property owners and particularly investors. Fewer properties available in the market will eventually lead to increasing rents and increasing prices. It is simply supply and demand and the market doing what it always does.  This is unlikely to be an advantage for first home buyers who are the intended beneficiaries of the changed legislation.  

Finally and crucially, with the proposed budget changes, we believe that there is a serious danger for investors. This is the case particularly where investors buy a poorly designed property. Many of the existing and new properties in the market today are not designed well enough to provide the residential amenity sought by owner occupiers.

There is a problem and it could be a very big problem for owners or purchasers of properties that are not designed well.  There are two types of buyers for residential property, owner occupiers who are buying to live in the property long-term and investors, some of whom don’t really care what they buy as long as they don’t pay too much and as long as the property is tenanted.   

In our opinion the proposed budget measures are going to have a profound effect in the future on purchasers who buy properties that don’t work for long term residential usage. The new measures will, we believe, encourage investors to buy new property rather than existing property so that they can take advantage of the enhanced depreciation benefits that will still be available to purchasers of new property. The same benefits will not be available to second and subsequent purchasers of a property.

An owner occupier will not buy a property that they cannot live in comfortably long term. So when an existing property is put to the market for sale in the future and if that property fails to meet the requirements of owner occupiers then it will be very difficult for the owner of the poorly designed property to find a buyer.

Poorly designed properties are going to be more difficult to sell in the future. They will certainly have a lower capital growth potential and reduced rental returns.

Fortunately, if you are receiving this article, you are a Hudson client and Hudson Financial Planning has always recommended new property as a preferred investment. And if you are referred to Specific Property we will only recommend properties that meet our and Hudson Financial Planning strict design criteria. 

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