Depreciation maximises your returns on investment property.
AS we've been saying for months, the residential investment property market was inevitably heading for a fall after three boom years. While it's taken longer than expected we're now starting to see the signs with falling auction clearance rates and rents combined with rising vacancies.
Over the next two years it will be a matter of investors making sure they maximise returns in a soft property market and that means understanding the benefits you can claim.
It's surprising to me how many investment property investors don't understand the tax implications of depreciation of those properties and what a major impact it can make on your total return.
I caught up with Yetkesh Reddy of specialists Australian Tax Depreciation Services last week to find out the finer points of property depreciation and assess the financial implications.
As the adjoining example shows, an average investor can cut his or her tax bill by more than $4400 through the power of depreciation and claiming the right deductions on the property.
First up, let's dispel the myth that you can only receive depreciation advantages on newly constructed properties. While depreciation rates vary across different properties and components, it applies to investment properties both new and old.
The Tax Office says that under income tax law you are allowed to claim deductions for expenses incurred in earning assessable income and rent is classed as income. The cost associated with the acquisition of capital assets, which provide benefit over their "effective life", may be written off over a period of time as tax deductions and this is essentially known as depreciation.
People fall into two big traps: they believe they can't depreciate their property because they think it's too old and they depreciate items which are really repairs and therefore deductible (but can't be depreciated).
In assessing whether a repair is an allowable deduction, the Tax Office looks at whether the claim relates to an actual repair or improvement.
The definition of repairs is an expense incurred in restoring an income-producing asset to the condition it was in when it first became income-producing and can then be claimed in the year the remedial works were undertaken.
An improvement, on the other hand, is not claimable as a direct deduction. But it may be depreciated under the capital allowance deduction over 40 years at a rate of 2.50 per cent per annum.
Repairs can include replacing broken windows, plumbing maintenance and repairs to electrical appliances.
Expenses considered improvements include insulating the house, painting, alterations and additions.
The biggest items that can be depreciated are the construction costs of the property and this is why new investment properties have higher depreciation levels than old properties. The construction costs also include design fees and building approval fees plus excavation costs.
Apart from the construction costs, some of the other most common items that can be depreciated at accelerated rates are: window coverings, including blinds and curtains; carpet and vinyl floor coverings; hot water units; whitegoods such as microwaves, washing machines, refrigerators, if they are owned by the investor; electrical appliances; and building services mechanical, electrical, fire, hydraulics and lifts.
In rental properties, there are items that are considered to be an integral part of the "setting" and do not qualify for depreciation as separate items of plant and equipment, but can be depreciated as part of the capital works.
They include built-in kitchen cupboards, clothes hoists, door and window fittings, driveways and paths, floor and wall tiles, garages and portable sheds, in-ground swimming pools, saunas and spas, reticulation pipe work, roller door shutters, rooftop ventilators and skylights, security doors and screens which are permanently fixed to the building, sinks, tubs and baths, wash basins and toilets.
David Koch is Channel Seven finance editor and hosts Sky Business Report on Sky News channel.
