Depreciation schedules are a key marketing tool for property developers, often highlighted to attract buyers seeking significant tax deductions.
The appeal is clear: compared to established properties, new properties often offer thousands of dollars in additional tax benefits each year, thanks to higher depreciation rates. For investors, this can seem like an opportunity to reduce personal tax burdens while holding an asset that may largely pay for itself.
However, the tax benefits brought about by depreciation are not given away for free. The ATO is not that kind. In fact, depreciation claimed today will likely cause a higher capital gains tax burden when time comes to sell that asset. Conveniently, a factor often missed by the slick marketing materials from developers.
A new property with a high level of claimable depreciation may instead be a cause for concern, as it suggests a significant portion of the sale price is tied up in inclusions that lose value, rather than what actually appreciates – land.
Cashflow Positive but Tax Negative
Negative gearing occurs when the expenses associated with an investment property—such as mortgage interest, rates, and maintenance—exceed the rental income it generates. This loss can then be offset against the owner’s other taxable income, like salary, reducing their overall tax liability.
Typically, negative gearing arises from cashflow losses, where the property costs more to hold each year than it provides in income. For example, interest payments on the mortgage may outstrip the rental income yield. This means the owner needs to pay out of pocket to keep the property.
However, depreciation can create a different scenario. It’s possible to have a negatively geared property that still generates positive cashflow, as seen below:
- Your investment property generates $10,000 in net income after all expenses (e.g., mortgage, rates, and maintenance) are paid. Normally, you would pay tax on this amount.
- However, because it’s a new property, you claim $20,000 in annual depreciation deductions.
- Subtracting the $20,000 depreciation from your $10,000 cashflow leaves you with a $10,000 taxable “loss.”
This “loss” can now offset other taxable income, such as your salary, despite the property actually providing you with positive cashflow. This is why depreciation schedules are often viewed as highly valuable when purchasing an investment property – they effectively create an immediate tax benefit while allowing you to hold an asset that may appreciate over time.
What is Depreciation?
Put simply, depreciation is the reduction in value of an asset over time due to wear and tear and general usage. For tax purposes, this loss of value is treated as a deductible expense that can offset income from other sources.
In the context of investment properties, depreciation is divided into two categories:
Depreciation of the Building (Division 43)
Also known as the capital works deduction, Division 43 allows property owners to claim a tax deduction for the decline in value of the building structure itself. This includes structural improvements like extensions, retaining walls, or fences.
For properties built after September 1987, the deduction is generally calculated at 2.5% of the construction costs annually, claimable for up to 40 years.
Importantly, Division 43 deductions remain consistent over this period, so it matters less whether the property is brand new or older (as long as it was built after the eligibility cutoff).
Depreciation of Fixtures and Fittings (Division 40)
Also referred to as plant and equipment depreciation, Division 40 applies to assets within the property that are not part of the building structure itself. Examples include air conditioners, carpets, ovens, and dishwashers—essentially items that are removable or replaceable.
The depreciation of these assets is calculated individually according to an effective life provided by the ATO. For example, carpets have an effective life of 8 years, meaning their value can be depreciated over this period.
The deduction is calculated using one of two methods:
- Prime Cost Method: This method spreads the depreciation evenly across the asset’s effective life. For an asset with an 8-year life, the deduction would be 12.5% of its cost each year.
- Diminishing Value Method: This method allows for higher depreciation in the earlier years of the asset’s life and less in later years, reflecting that assets lose more value when new. For example, the drop in value between a brand-new dishwasher and a one-year-old dishwasher is often much larger than the drop between its 9th and 10th years.
Why New Properties Often Have Higher Depreciation
The depreciation schedule of a new property is heavily influenced by the developer’s decisions regarding the property’s fit out. Luxury inclusions such as marble floors, high-end appliances, or even pools typically result in significantly higher depreciation deductions compared to more modest fit outs.
This may help explain why nearly every apartment development is now marketed as ‘luxury’. Developers benefit from the higher profitability of premium finishes while leveraging the larger depreciation schedules to attract investors seeking significant tax deductions.
Properties with higher depreciation deductions often have a much lower land-to-asset ratio. This is especially true for apartments, where the land value apportioned to each unit is much lower than the value of the property itself—sometimes as low as 10% to 20% in high-rise developments.
While it’s commonly said that land appreciates and buildings depreciate, assuming a house on land will always outperform an apartment oversimplifies the issue. Highly sought-after apartments in areas with high land values and strong demand often outperform properties with greater land proportions but less appeal.
Depreciation and Capital Gains Tax
As mentioned previously, depreciation is not money for nothing. It can have a real impact on the eventual capital gains tax payable on the property, though the effects differ depending on the type of depreciation claimed.
Building Depreciation (Division 43)
Division 43 is straightforward. Each dollar claimed in depreciation for the building’s structure directly reduces the property’s cost base by the same amount.
The cost base includes the purchase price, stamp duty, and other acquisition costs. When the sale price exceeds this adjusted cost base, a capital gain is made. Since Division 43 deductions lower the cost base, they increase the difference between the adjusted cost base and the sale price, thereby increasing the taxable capital gain and the associated tax liability.
Depreciation of Fixtures (Division 40)
Division 40 deductions apply to individual assets within the property, such as appliances, carpets, and other removable fixtures. These assets are treated separately for tax purposes and are not included in the property’s overall cost base.
When these assets are sold, they are generally valued at their depreciated value. This means that the depreciation previously claimed does not directly impact the capital gains tax calculation, since the sale price of the assets equals the depreciated value. There is no capital gain to be had.
Since these assets are not part of the capital asset itself, claiming Division 40 deductions does not reduce the cost base of the property or increase the taxable capital gain.
Hypothetical Scenario
To understand this in practice, consider an unlikely but not impossible hypothetical. This highlights the impact claimed depreciation can have on a capital gains tax event:
- You purchase a brand-new investment apartment for $1,000,000 and incur $60,000 in acquisition costs, bringing your initial cost base to $1,060,000.
- 7 years later, you sell the property. The market hasn’t performed well during this time, and you achieve a net sale price of $950,000. At first glance, it seems like you’ve made a loss of $110,000 compared to your original cost base, which suggests no capital gains tax would apply.
- However, during these seven years, you’ve claimed $130,000 in Division 43 (building depreciation).
- This deduction reduces your cost base, which is recalculated as:
$1,060,000 – $130,000 = $930,000. - With the adjusted cost base of $930,000, the sale price of $950,000 now exceeds it, resulting in a capital gain of $20,000. Since the property was held for over 12 months, the 50% CGT discount applies, reducing the taxable gain to $10,000.
To add insult to injury, the investor in this scenario faces a capital gains tax bill even though the actual sale price of the asset is lower than the original purchase price. They will have received the tax benefits of the depreciation over the years of ownership, but it’s likely these will quickly be forgotten at sale time.
Whilst this may seem like a fanciful situation, property markets are not immune to price drops. Even in recent years, properties within high-grade areas of Sydney & Melbourne have seen similar declines in price. These tend to be apartments that have been purchased new, directly from developers.
Summary
Claiming Division 43 depreciation deductions on an investment property will reduce the property’s cost base, affecting its capital gains tax treatment. However, the immediate tax benefits from these deductions still generally outweigh the potential increase in CGT liability when the property is sold.
This is because depreciation reduces your taxable income at your full marginal tax rate in the year it is claimed. Whereas capital gains are effectively taxed at half your marginal rate (if the property is held for more than 12 months, qualifying for the CGT discount).
However, it’s important to remember that these deductions are not “free money.” They represent a trade-off that reduces your cost base and increases your future tax liability upon sale.
Evaluating an investment purely on potential tax benefits is rarely the best approach. While tax considerations are important, allowing them to drive your investment decisions can expose you to undue risk.
For example, the property in our example might have been priced at a premium due to high-end inclusions that resulted in larger depreciation claims. The developer may have intentionally fitted out the property to appeal to tax-focused investors, despite it being overpriced.
Depreciation as a word means something is losing value. In the case of a property, if the capital growth of the land is not outpacing the depreciation of the building, the asset is losing value. By definition, this would be a pretty bad investment.
Ultimately, don’t let the tax tail wag the investment dog.
