As a residential investment property owner, a unit owner of a real estate trust or an entity that owns investment properties, understanding the types of depreciation in real estate will enable you to take full advantage of the available depreciation discounts. Claiming a maximum depreciation deduction can make a significant difference to cash flow by reducing assessable income in the fiscal year in which it is applied.
The Australian Taxation Office (ATO) allows income-producing property owners to claim a depreciation deduction for normal damage to a building and items in it against their assessable income. Depreciation tax credits are generally higher on new properties when using the decreasing value method that applies a higher rate of depreciation in the first years of owning the asset. However, depreciation is available for all types of investment properties which is critical to maximizing deductions.
To claim depreciation, property owners must arrange for a certified quantity surveyor to inspect the property and prepare a property tax depreciation schedule. On-site inspections are necessary to meet ATO requirements.
The table lists all depreciable items, including the actual life remaining on each item and the dollar value that can be claimed against your assessable income. Depreciation will include the allowance for building (structural), plant and equipment as well as the recording of any renovations that have been made to the property since the initial construction. You can learn more about the property’s depreciation schedule and what owners are entitled to here.
As tax time approaches, we’ve answered some of the most frequently asked questions regarding types of depreciation. Real estate investors should seek independent advice from a tax accountant or professional to help you better understand the value of property impairment and the deductions you may be entitled to based on your individual circumstances. Investors in real estate trusts should also request information from the fund manager for general information and from a tax accountant for advice about their personal circumstances. For Trilogy Funds investors, details can be found in our annual tax statement, and our investor relations team is available to assist with any investor inquiries.
What is consumption?
Depreciation is a key component of a real estate investing strategy, so it’s important to understand what that means. According to the ATO, “An asset that is depreciated is an asset that has a finite effective life and can reasonably be expected to depreciate during the time in which it is used.”
As the property ages, the architecture of the building and the assets in it fade away. In this context, depreciation of real estate is an allowable deduction that provides investors with the ability to offset the depreciation of their investment properties from their taxable income.
What are the types of depreciation?
Depreciation deductions are divided into two different categories:
Section 43 – Capital Work Allowance
Capital work may include building or expansions, alterations or improvements to a building and allowance refers to claims for wear and tear to the structure of the property, including any fixed items such as brickwork, roof, walls, doors and kitchen cabinets.
Owners of income-producing properties are entitled to claim the capital work deduction. The percentage of the deduction and the number of years that can be claimed is determined by the type and date of construction as well as the intended use of the building. The ATO provides information regarding claim limits for capital business deductions and important factors that aid in the settlement of claims here.
As a general guide, real estate investors who own residential properties built after September 15, 1987 can claim a capital work deduction at a rate of 2.5% per year for 40 years. For residential properties that have undergone structural improvement after February 27, 1992, investors can claim a capital work deduction for the construction cost of 2.5% annually for 40 years from the date construction was completed.
For commercial and industrial properties, a capital work deduction of 2.5% or 4.0% per annum can be claimed. The price is determined by the date of commencement of construction, type of capital work and nature of use.
It is important to note that claiming capital business allowance depreciation deductions may affect your capital gains on your assets. It is essential to seek independent advice from a professional for your personal circumstances.
Section 40 – Depreciation of Plant and Equipment
Depreciation of plant and equipment can be claimed on removable fixtures and fittings within the property. ATO identifies more than 6,000 different consumable assets, including items such as carpets, curtains, air conditioners, hot water systems, smoke alarms, and ceiling fans. Depreciation deductions for these assets are calculated over their individual actual life, as provided by the ATO.
Under current legislation, owners of second-hand residential property who exchange contracts after 7:30 p.m. on May 9, 2017 cannot claim a deduction for previously used plant or equipment assets. Investors who purchase new residential property and substantially renovated properties or add new plant and equipment assets to a used residential property can still claim a significant depreciation deduction.
Owners of commercial and industrial property can claim depreciation of any assets they own within the property. Any applicable discounts will be subject to the quantity surveyor’s report.
What are the methods used to calculate depreciation?
In general, plant and equipment assets costing $300 or less can generally be claimed as an immediate deduction, while assets costing more than $300 must be depreciated over their estimated useful life. It is important to note that these deductions are subject to a number of tests from the ATO which you can learn more about here.
To calculate how much depreciation can be claimed on plant and equipment assets within income-producing property, there are two methods that can be used:
The prime value method (also known as the straight line method) states that owners can claim a fixed percentage of the asset’s value over the life of the asset. Using this method allows owners to claim a lower but more stable percentage each year.
The basic premise of the declining value method is that the decline in value each year is a constant percentage of the residual value and produces a progressively smaller decline over time. Using this method allows owners to claim higher discounts in the early years of the asset’s actual life.
There are two areas to which impairment will be applied:
Accounting depreciation (also known as written depreciation) explains the decline in asset values within a company’s financial records. Effectively, depreciation of these assets is an expense for a business and should be included as such when calculating profit. The calculation of the decline in assets will give a true indication of the financial position of the company.
Tax depreciation is the process of applying the depreciation of assets in accordance with tax legislation. Tax depreciation is reflected in the investor’s annual tax statement in the form of deferred tax amounts or assessable reduced income and is generally the second largest deduction for real estate investors, after interest.
How does depreciation affect the investment in my property fund?
Real estate fund investors residing in Australia for tax purposes may be entitled to receive deferred tax payments, which reduce the amount of income tax due from an investment trust in a given financial year. Tax-deferred distributions generally arise due to non-cash deductions or tax liens such as depreciation. Income tax may not be payable on tax-deferred amounts, with the tax liability deferred until a capital gain (if any) is realized.
ATO has great capabilities in data matching and information gathering covering many capital transactions and investment income streams. It is important to accurately report investment income, including from abroad, keep accurate records, properly calculate capital gains or losses, and comply with the various rules and perks available to you as an investor.
What happens to depreciation claims once the building is sold?
Once an investment property is sold and settlement is complete, the seller can no longer claim depreciation and the current depreciation claim is taken into account in the sale account. Any remaining capital work receivables will be transferred to the next owner if he continues to use the property for income-producing purposes.
When selling a property, investors will need to consider the implications of a capital gains tax (CGT). CGT is a tax levied on the profit or capital gain from the sale of an income-producing asset. CGT is very complex, with many factors affecting its application, including the time of acquisition of the drug. You can read more about capital gains tax here.
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