Depreciation schedules: the deduction most landlords miss

Depreciation is the largest deduction available to most property investors and the one most frequently left unclaimed. It requires no cash outlay in the year it is claimed, it applies whether or not the property is positively geared, and it is available to anyone who owns an income-producing property. The obstacle is that claiming it properly requires a report most investors have never been told to commission.

Two separate deductions

Property depreciation splits into two categories that are calculated differently and have different rules.

Division 43 covers capital works: the building structure itself, plus permanent fixtures such as walls, roofing, kitchen cupboards, tiling and driveways. It is deducted at 2.5% a year over forty years for residential properties built after 15 September 1987. On a building with a construction cost of $300,000, that is $7,500 a year, every year, for four decades.

Division 40 covers plant and equipment: the removable assets inside the property. Ovens, dishwashers, air conditioning units, carpets, blinds, hot water systems, smoke alarms. These depreciate over their individual effective lives, which are much shorter, so the deductions are larger in the early years.

The 2017 rule change

Legislation from 1 July 2017 removed Division 40 deductions on previously used plant and equipment in second-hand residential properties. If you bought an established home after that date, you generally cannot depreciate the existing oven, carpet or air conditioner.

This is where most investors stop, and where most of them are wrong. Three things survive the change.

Division 43 capital works deductions are unaffected, and on most properties that is the larger of the two amounts. Plant and equipment you purchase and install yourself after settlement is fully depreciable. And the rules do not apply at all to new residential properties, substantially renovated properties, or properties held in a company or through certain trusts.

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The 2017 change removed one of the two deductions on second-hand homes. The other, and usually the larger, is still fully available.

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Why you need a quantity surveyor

The ATO accepts construction cost estimates from an appropriately qualified quantity surveyor. Your accountant cannot estimate them, and neither can you, unless you have the original building contract and it itemises the costs.

A schedule costs a few hundred to around a thousand dollars depending on the property, is itself fully deductible, and typically returns several times that in the first year alone. It runs for forty years, so it is commissioned once rather than annually.

Most surveyors will assess whether a report is worthwhile before charging you. For a small, old, unrenovated property they will sometimes tell you it is not. That is a reasonable answer and worth asking for.

Missed it in prior years?

You can generally amend the last two years of individual tax returns to include deductions you did not claim. If you have owned the property longer than that, the earlier years are usually closed, but the schedule still runs for the remainder of the forty-year period.

We see properties held for six or seven years with no schedule ever prepared. Commissioning one now recovers two years by amendment and the rest going forward. The years in between are simply gone, which is why it is worth doing in the first year of ownership.

What it means at sale

Depreciation is not free money. Division 43 deductions claimed reduce the cost base of the property, which increases the capital gain when you sell.

That still leaves you ahead in most cases. The deduction is claimed at your full marginal rate each year, while the additional gain is typically taxed after the 50% general CGT discount where the property has been held over twelve months. Deferring tax for years and then paying it at half the effective rate is a favourable trade.

Division 40 assets are handled separately at sale through a balancing adjustment, which is another reason to keep the schedule rather than discard it once the property is sold.

The practical step

If you own an income-producing property and have never had a depreciation schedule prepared, get a quantity surveyor to assess it. If they say it is worthwhile, commission the report and send it to your accountant. If they say it is not, you have spent nothing and can stop wondering.

It is the rare piece of tax advice that takes one phone call.