The recent depreciation changes have the greatest impact on the types of property you may choose to invest in. Some people prefer to invest in brand-new properties, while others opt for older property that they can renovate and resell for profit. So, which is the better investment strategy? Let’s look at this in actual finite details. If you look at Table 5.1 below, you’ll see the net effect of the cost of owning a property broken down into three examples:
a brand-new property;
a property built between 1987 and 2016; and
a property built before 1987.
At the time of writing this book in 2017, the middle column is 2016 because it’s one year prior to the current year. This highlights that the property is second-hand and you will be acquiring previously used assets if you purchase it now. If you’re reading this in 2019, the middle column will be 1987 to 2018; one year less than the current year.
Depreciation on three types of residential investment property
The assumptions are the same for every property: each one will generate a weekly rental income of $700 over a 52-week period, which works out at $36,000 per property. Furthermore, the interest rate is 5.5 per cent on each property on borrowings of 80 per cent of the purchase price – that’s an annual interest bill of $33,000 which is the same to illustrate the net effect on depreciation. Each property will have other expenses at 1.5 per cent of the purchase price, which makes $11,250 annually for each property. Now, you could argue that property built before 1987 could have higher expenses, but for ease of comparison we’ve kept the same rate. So, it’s the same scenario for each property with the net outlay before depreciation of $7,850. Now, here’s where things get interesting, what about the depreciation?
In a brand-new property, the depreciation in year one is $15,000;
For the property built between 1987 and 2016, it’s $4,000 because all you claim there is the structure of the building; and
For a property built before 1987, the depreciation is $0.
Depreciation on a brand-new property
You can see that the total tax loss on the brand-new property is quite high at $22,850. If you are an investor who is paying tax at a marginal tax rate of 37.5 per cent and you’re making a loss of $22,850, you will receive a tax cheque back from the ATO to the tune of $8,455 – and that’s cash in hand. However, you have physically paid out $7,850, remember? You’ve been paying $605 a year to own that property – so the net return is $12 a week positive cash flow.
Depreciation on an old property
Next, let’s look at the property built before 1987. Again, you have physically paid out $7,850 over the year to hold the property. You can’t claim any depreciation on your investment, so the total tax loss continues to be $7,850. If you are in the 37 per cent income tax bracket, there will be a tax return of $2,905. Given that $7,850 has been paid out and there’s a tax cheque of $2,905, it’s cost you roughly $5,000 per year to own. That’s just under $100 per week to own a property built before 1987.
Depreciation on a second-hand property built between 1987 and 2017
Using the same variables, if you bought a property built between 1987 and 2017, your annual tax loss would be $11,850, so you would receive a tax refund of $4,385 (providing you are in the 37 per cent bracket). Your cash outlay was $7,850, so your annual cash outlay is $3,465. That means your weekly cash flow is negative $66, but you’ll still eventually realise a capital gain over the medium to long term. As you can see, there are pros and cons of buying brand-new and almost-new properties, depending on your investment strategy. Furthermore, buying brand-new property often carries the developer’s profit, which you pay for in the purchase price. If you buy something ‘newish’ – say a five to ten-year-old property – there is a fair chance that it has been bought and resold a few times. Therefore the value is now reflected in a more realistic way on the open market.
There is a common misconception in the property market that you cannot claim depreciation on old properties. This is wrong, and I can prove it!
The origin of this myth centres on the fact that you cannot claim building depreciation on residential properties where the construction commencement date is before 1987.
This is a true statement and put simply means that you can’t claim depreciation on the structure of the building – the brickwork and concrete – if it was built before 1987.
But here’s the rest of the story. While it is true that the government has disallowed claiming depreciation on previously used assets, all properties built after 1987 will still qualify for the building allowance – making it worthwhile to order a depreciation schedule.
Further, it is pretty rare these days that when we inspect a property built before 1987, there hasn’t been some form of kitchen or bathroom renovation carried out – and the renovation resets the start for those works and thus can be claimed by the incoming property investor.
The best way to test how much you can claim on an old property is to use the Washington Brown depreciation calculator. Here you can crunch the numbers on your property and see how much you can claim. All you need to do is answer some simple questions about the property in question.
This calculator has now been updated to reflect the changes announced in the 2017 Budget.
Try Washington Brown’s proprietary Property Depreciation Calculator
This is the first calculator to draw on real properties to determine an accurate estimate. It allows you to work out the likely tax depreciation deduction on your investment property.
This is the only calculator in Australia that enables you to enter a purchase price and get a depreciation estimate as a result. It took me four years to build, because it relies on real life data and is very complicated to say the least.
How can brand new property help investors with their cash flow?
(UPDATE – Since the 2017 Federal Budget, brand new property has become even more attractive in tax depreciation terms, as it is exempt from the changes – Read about the Budget changes here).
Buying new property will help investor cash flow due to greater tax depreciation benefits. Tax depreciation benefits are at their greatest when the property is brand-new, which maximises your available tax deductions and means a significant boost to your cash flow position.
Exactly how can a brand new property depreciation benefit an investor’s tax position?
Depreciation allowances for new properties can yield big tax breaks. Investors can claim 2.5% depreciation allowance of the construction cost plus you’ll also be entitled to claim the full amount of depreciation allowance on plant and equipment items such as blinds, ovens, carpets, air conditioners etc, which will all be brand new.
By way of example, the owner of a brand-new Melbourne high-rise unit, recently purchased for $440,000 claimed $12,000 in depreciation in the first year.
Investors also have the option of having a variation on their take-home pay by having the depreciation schedule sent to their employer. Varying your tax withholding will assist property investors with their cash-flow on a more regular basis.
What should investors do to maximise their tax benefits?
A dollar today is worth more than a dollar tomorrow so deduct items as quickly as possible. Individual items under $300 can be written off immediately. A microwave for example, bought for $330 depreciates at 37.5% but at $295 it’s 100%.
You can also try to buy items that depreciate faster. Items between $300 and $1000 fall into the Low Pool Category and attract a higher depreciation rate. So for instance, a $1200 television attracts a 20% deduction while a $950 TV deducts at 37.5% per annum.
The ownership structure of your investment property should also be a key consideration for investors.
For multiple owners of a property, ask your quantity to surveyor to split the value of assets in the property against the split of ownership rather than one report that is divided by the number of owners at the end.
Doing so will significantly increase your tax deductions as numerous items will be pooled into lower categories that attract higher depreciation rates.
Furnishing your investment property is also a good way to maximise your depreciation because they attract higher rates. For instance, $20,000 worth of furniture could equal $10,000 in year 1 – but investor’s must be smart about their purchases.
Are the tax benefits best in the first few years? Why?
If you claim using the Diminishing Value (DV) method you claim a greater proportion of the asset’s cost in the earlier years of its effective life.
Using the Prime Cost (PC) method you claim a lower but more constant portion of the available deductions over the life of the property.
The ATO also allows plant & equipment items to be given a new effective life from settlement date, whether new or second hand and regardless of age.
Therefore plant and equipment items can be re-valued based on the purchase price of the building at their settlement date.
Most investors employ the diminishing value method, as depreciation deductions under this method are higher during the first five years of ownership.
This means investors receive a greater deduction in the early years, when it is often most required.
Can you provide an example of the difference between the depreciation of a new property and an older one?