Property depreciation can save our clients a lot of money. But the rules around property depreciation are confusing at the best of times. So, we asked BMT Tax Depreciation to help us out. BMT prepares around 70,000 property depreciation schedules a year. So, you would think that they know a thing or two about property depreciation. Here is what we learned from them.
Let’s start at the very start and then get into the nitty-gritty details. Property depreciation allocates the cost of a building’s structure as well as plant and equipment over the life of the relevant assets.
There are different methods of property depreciation depending on the type of asset and its cost. The reason that all this is so confusing is that these often overlap. You might qualify for the $300 immediate deduction but also for the low-value pooling for example. And then there quite a few ifs and when you can claim around each depreciation method.
Division 43 is about the depreciation of a building’s structure and fixed items. An example of a fixed item would be a roof, wall, window, door, toilet, bath or kitchen cupboards and tiles. This deduction under division 43 is also called a capital works deduction.
This division 43 capital works deduction is a straight-line depreciation, for most newer buildings at 2.5 per cent. So, this method evenly distributes the cost over forty years.
Division 43 deductions typically make up at least 85 to 90 per cent of the total claimable amount.
There are three main areas you can’t claim a Division 43 deduction for. These are land, soft landscaping and residential properties that commenced construction before the 15th of September 1987.
The last one often takes investors by surprise. If you like to invest in Victorian terraces, you can’t depreciate the original structure or any renovation that happened before the 15th of September 1987.
So, whenever you buy a residential property, always find out when it was built or substantially renovated. You can’t claim a division 43 deduction for anything that happened before the 15th of September 1987.
If a builder spends $500k to build a bare structure without any furniture and fittings and I buy it for $1m, how much can I claim?
Only the $500k. The $1m would include the land, soft landscaping plus the builder’s profit margin. Neither of those are depreciable.
If somebody bought this bare structure four years ago and claimed $50k in division 43, how much can I claim now as the new investor?
The answer is $450k over the remaining thirty six years. A new investor can only claim capital works deductions (Div 43) over the remaining years of the property’s life.
That is for the ‘old’ structural part of the property you just bought. But if you then add a ‘new’ structure, you can claim the full costs of this ‘new’ work as capital works deductions over forty years. All this occurs only if and when the property is used for income producing purposes.
Can I claim Division 43 for an apartment?
You can claim Division 43 for an apartment. You don’t claim the full construction cost but only the portion that relates to your share of the building.
How are repairs and maintenance different from capital works?
Repairs are works completed to fix damage or deterioration of a property, for example replacing part of a damaged fence.
Maintenance is work completed to prevent deterioration to a property, for example oiling a deck. Any of these can be claimed as an immediate deduction in the year of the expense provided they meet the requirements of s8-1. Depreciation doesn’t apply.
Division 40 is about the depreciation of plant and equipment. For property investors these are the mechanical or easily removable assets found within a property, including the furniture and fittings. Examples are carpets, hot water systems, garbage bins, smoke alarms, air conditioners and blinds or curtains. These deductions, under division 40, are often referred to as a capital allowance.
This capital allowance under division 40 allows investors to choose between two methods of claiming depreciation for any property – the diminishing value and the prime cost methods.. Both methods claim the total depreciation value available over the life of a property, but use a different formula.
The diminishing value method calculates the deduction as a percentage of the previous year’s closing balance, aka this year’s opening balance. For properties settled on or after the 10th of May 2006 the formula is:
- Opening balancex 2/asset’s effective life (in years)
The prime cost method calculates the deduction for each year as a percentage of the cost. It is basically a straight-line depreciation claiming the same deduction each year as:
- Asset cost/asset’s effective life (in years)
When should I use the diminishing value method and when not?
The diminishing value method results in a greater claim of the asset’s cost in the earlier years of the effective life of an asset. While the prime cost method uses a lower but more constant proportion of the available deductions over a longer period.
So, what method to use depends on the taxable income and tax brackets over the relevant years.
What happens if I use an asset for less than 365 days/ year?
You can pro-rata the deduction. If an investor owns an asset or uses it for income producing purposes for less than 365 days in a year, you pro-rata the deduction by days owned/365. This applies to both division 40 and division 43.
Is everything in a building either division 43 or division 40?
No, there are many elements that are neither division 40 nor division 43 and hence can’t be depreciated. Examples are land and soft landscaping. Investors also can’t claim any division 43 deductions for the original building structure or renovations started prior to the 15th of September 1987 and of course any builder’s profit.
Land can’t be depreciated since it doesn’t suffer from wear and tear.
Examples of soft landscaping, include grass, shrubs or trees.
Anything that you construct outdoors, for example a retaining wall, would fall under division 43 though.
Do division 40 and 43 apply both to passive investments as well as active assets?
Yes, they do but division 40 with some exceptions. Division 43 and in general also division 40 apply to any income producing activity, be it to just collect rent (passive income) or to use the property in a business (active asset). The exception in division 40 relates to the immediate deduction for plant and equipment under $300. That deduction is only available for non-business assets.
Is it ‘safer’ to use the Commissioner’s rates rather than self-asses?
Yes, it usually is. The Commissioner regularly publishes long tax rulings about the effective life rates for a wide area of assets. And this is what BMT uses in their tax depreciation schedules unless a client requests otherwise.
You can self-assess the effective life of an asset in some cases, but there is an element of risk. The Australian Taxation Office (ATO) might question the deductions claimed in this scenario. Adhering to the rates listed in the relevant tax rulings reduces the chance of a dispute with the ATO.
$300 Immediate Deduction
You can claim an immediate deduction under s40-80(2) for any plant and equipment under division 40 that cost less than $300 and is a
This depreciation is part of the Uniform Capital Allowance system (UCA) in division 40. You can only claim an immediate deduction for plant and equipment costing less than $300 if:
- It is a non-business asset. The immediate deduction is only available for assets that are mainly used for non-business assessable income. So,property investors qualify with flying colours. Business assets don’t. But for that business assets get the $100 deduction – little consolation though.
- The asset is NOT part of a set of assets that together cost more than $300. Otherwise you could just break any asset down into its thousands of components and immediately deduct them all The asset is NOT one of a number of identical or substantially identical assets that together cost more than $300.
$ 100 Threshold Rule
This one is only for small business, so property investors are out. A small business can immediately deduct all business assets that cost less than $100. So, if your property is a business asset, this one would be for you.
$1,000 Low-value Pool
Property investors can use low-value pooling to depreciate plant and equipment at a higher rate. It doesn’t matter whether the asset is used for passive income or as an active asset. The low-value pooling is available for investors and business alike. A low-value pool can include low-cost assets as well as low-value assets.
A low-cost asset is a depreciable asset that originally cost less than $1,000.
A low-value asset is a depreciable asset that originally cost more than $1,000 but that now has a written down value of less than $1,000.
An example of a low-value item could be a hot water system costing $1,100. In the second financial year the asset would have depreciated to a written down value less than $1,000, which would make it eligible to be placed in the low-value pool.
There are a few instances where you can’t use low-value pooling though. For example, when you use the:
- $300 or $100 immediate deduction, or
- $20,000 Div328 Instant Asset Write-Off, or
- Prime cost method for this asset, or
- For portable electronic devices, computer software, protective clothing and tools of trade that you provide to an employee.
$20,000 Division 328 Instant Asset Write-off
This one is also called the simplified depreciation rule and is only available for business assets. So not relevant for the pure property investor deriving passive income.
If a business’ aggregated turnover is below the relevant threshold for the year – currently at $10m – the business can claim an instant asset write-off for any asset costing less than $20,000. This tax concession has been extended to June 30, 2019.
Hotels, motels, industrial buildings, warehouses, storage sheds, petrol stations, pubs, vineyards, preschools, shopping centres, nursing homes, factories, offices, medical centres, restaurants and cafes are all examples where the instant write-off might apply.
Changes to Division 40 from 7:30pm on the 9th of May 2017
So, this is the big one. Everything we discussed so far still applies but we skirted around some the issues that second-hand residential properties now face with respect to division 40.
The 9th of May 2017 federal budget changed the way division 40 works for ‘used’ furniture and fittings (plant and equipment).
Before this day, all property investors acquiring a second-hand residential property could claim division 40 depreciation for previously used (or pre-existing) plant and equipment.
This has now changed. Property investors who purchase a second-hand residential property after 7:30pm on the 9th of May 2017 will no longer be able to claim depreciation on previously used plant and equipment assets in their property.
But they can still claim a division 40 deduction for new plant and equipment they bought themselves. And they can still claim division 43 if applicable.
New property is not affected by these changes. For new property, division 40 applies as it did before the 2017 budget. For a new property a capital allowance (division 40) can be claimed for plant and equipment based on their effective life and actual cost just as before.
Is the cut-off date exchange of contracts or settlement?
It is the date of exchange of contracts, just as it is for Capital Gains Tax (CGT) purposes. The new rules apply only to those investors who exchange contracts on a second-hand residential investment property after 7:30pm on the 9th of May 2017.
For investors who exchanged contracts prior to this date the rules have been grandfathered. This means that those investors who exchanged contracts prior to 7:30pm on the 9th of May 2017 can continue to claim depreciation using the existing rules.
What about developers who rent out before sale?
Developers who build a new residential property will have a six-month grace period in which they can rent out the property (when they can’t sell straight away) and will continue to be able to sell the property to an investor with full depreciation entitlements.
In this scenario the property is trading stock. And the Developer can’t claim any depreciation while they are renting the property.
What about main residences turned into rental properties?
It depends. Depreciation deductions only apply to owners of income producing properties and not home owners. However, if an owner-occupier turns their home into an investment property, they can claim depreciation under division 40 but how much depends on the timing.
Owners can continue to claim division 40 for plant and equipment in main residences turned into an investment property prior to the 1st of July 2017.
However, if home owners rent their main residence out after the 1st of July 2017, plant and equipment are no longer new and hence no division 40 deduction. But if the owners then buy new plant and equipment, they can fully depreciate these ones, just not the ‘old stuff’.
What about a renovation?
If the current owner renovates, then not just the costs for the capital improvement but also the costs for new plant equipment may go into a tax depreciation schedule. So, the schedule will include both capital works deductions (division 43) as well as capital allowances for plant and equipment (division 40). Provided the rental period started before these costs. And this is the crux. Big renovations will probably happen without a tenant in the middle of it.
If it is the previous owner who renovated and the new owner bought after the 9th of May 2017, then the new owner can claim the capital works deduction (division 43) for any structural work, but not for ‘used’ plant and equipment. Instead, these assets will be included in a capital loss depreciation schedule for the purposes of claiming a capital loss, allowing the owner to adjust their CGT liabilities where applicable.
What about a substantial renovation?
A substantial renovation is treated like a new property. If a previous owner does a substantial renovation to sell, then an investor can claim division 43 as well as division 40.
Substantial renovation works can be structural or non-structural.
Examples of substantial structural work include replacing foundations, floors, supporting walls, or parts thereof, be it interior or exterior, modifying a roof, replacing existing windows and doors requiring brick work.
Examples of substantial non-structural works include replacing electrical wiring or plumbing, replacing, removing or altering non-supporting walls, or parts thereof (interior or exterior), plastering or rendering an entire wall or walls, removing or replacing kitchen cupboards, bathroom fixtures, air conditioning or security systems.
But cosmetic changes are not substantial changes. Examples of cosmetic changes are painting, sanding floors and replacing lights, curtains or carpets.
According to s 195-1 ITAA 97 a substantial renovation is a renovation ‘in which all, or substantially all, of a building is removed or is replaced’.
Substantial renovations affect the building as a whole and the renovations need to result in the removal or replacement of all or a substantial amount of the building.
Who do the changes NOT affect?
For all the media coverage about the changes, it is easy to forget that there is a long list of scenarios and entities who the changes don’t affect, such as:
- Owners of brand new residential properties, regardless of when purchased.
- Residential property investors who exchanged contracts prior to 7:30pm on the 9th of May 2017. However, a property owner can’t claim depreciation on pre-existing plant and equipment in their primary place of residence when they decide to rent the property out after the 1st of July 2017
- Properties considered substantially renovated by the previous owner
- Plant and equipment the current owners install and incur the expense for
- Non-residential/commercial properties
- Deductions that arise in the course ofcarrying on a business
- Superannuation plans (other than Self-Managed Super Funds) that hold residential property
- Public unit trusts and managed investment trusts
- Corporate tax entities – but not corporate trustees
Do the changes affect the CGT cost base?
When a cost no longer qualifies for a deduction, it goes into the cost base for CGT purposes. So, the changes might affect the amount of the cost base. But they don’t affect HOW to determine the CGT cost base.
Does a depreciation schedule still makes sense?
You need a depreciation schedule if you want to claim deductions to save tax. And want to avoid the ATO coming after you for shoddy estimates.
Remember that on average 85 to 90 per cent of a property’s depreciation comes from division 43. And division 43 has been unaffected by the changes. And you can still claim division 40 for a range of scenarios. So, a depreciation schedule still makes sense in most cases.
Can you give a before and after example of the change?
Here is an example of two properties, a new residential unit and a two year old residential unit. Both were purchased for $700,000 after the 9th of May 2017. Let’s see how the deductions vary using the diminishing value method.
New residential unit
First full year $14,600
Five years cumulative total $59,800
Two year old residential unit
First full year $8,200
Five years cumulative total $41,000
The difference is usually greatest in the first year and decreases over time. And remember that over the entire life time of the asset on average 85 to 90 per cent of all deductions come from div 43. And div 43 didn’t see any changes.
So, these are the various methods of property depreciation that might be available to you. To do this properly and survive an ATO audit, you need a property depreciation schedule. A Quantity Surveyor will list all the relevant low-value pooling and immediate deductions as well as division 40 and 43 in such a property depreciation schedule for you.
Quantity Surveyors are qualified professionals who specialise in building measurement and estimating the value of construction costs.
There are many Quantity Surveyors out there but BMT is probably the market leader for individual investors with around 70,000 depreciation schedules issued each year. BMT started in 1997 with offices in Sydney and Newcastle, but now provides an Australia-wide service with twelve offices across Australia.
We spoke with Bradley Beer, the CEO of BMT, on 17 May 2018.
Disclaimer: Tax Talks does not provide financial or tax advice. This applies to these show notes as well as the actual podcast interview. All information on Tax Talks is provided for entertainment purposes only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 21 Jun 2018