How ignoring depreciation shoots you in the foot

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You can be forgiven if you’ve heard of depreciation, but don’t know entirely how it works – few do. In reality, it is fairly simple and can dramatically improve your property’s cash flow

 

Depreciation is the generic accounting term used to describe how an asset declines in value over time and is accounted for with a taxpayers return.

In property investment terms, it is a legislative allowance made under the Income Tax Assessment Act (1997) to recognise the decline in value of the physical asset, during a period where it is used to produce an income.

Depreciation of an investment property is based on its ‘useful life’, or the number of years a property is expected to be in use. Depending on the type of property and when it was built, a property’s useful life ranges from 25 years to 40 years.

Investment properties can depreciate in two ways – depreciating assets and building allowance depreciation.

All investment properties experience depreciation in the first category, more commonly referred to as plant, articles and machinery. Depreciating assets include items such as:

  • Carpet
  • Ovens
  • Cook-tops
  • Dishwashers
  • Clothes dryers
  • Blinds and curtains
  • Air conditioners
  • Heaters
  • Hot-water systems.

For these items, depreciation is based on the acquisition cost of the item, which may vary in value depending on the type of asset. Carpet, for example, can vary in price and quality, and this will be reflected in the depreciation allowance.

Some investment properties also qualify for the second type of depreciation: ‘capital allowance’ or ‘building allowance’ depreciation.

In this case, depreciation is related to the building itself, and is based on the cost of construction of the building rather than the acquisition cost. For example, you might pay $500,000 for a property, with the land portion accounting for $275,000, and the actual building cost being $225,000.

Capital allowance depreciation ranges from 2.5% to 4%, depending on the type of building and when it was constructed.

For residential properties, depreciation on the building is calculated at a rate of 2.5% per annum if construction started after 16 September 1987, and 4% if construction started between 18 July 1985 and 15 September 1987. Residential properties built prior to 18 July 1985 do not quality for building allowance.

For commercial properties, depreciation is calculated at a rate of 2.5% per year if construction started between 21 August 1979 and 21 August 1984, or from 16 September 1987. A rate of 4% applies if construction started between 22 August 1984 and 15 September 1987.

How do quantity surveyors fit in?

Quantity surveyors are one of few professionals recognised by the Australian Taxation Office (ATO) to determine the cost of building components for tax depreciation purposes. 

Other professions, such as real estate agents, valuers, solicitors and accountants, are not recognised by the ATO as being able to determine the cost of construction.

Quantity surveyors determine the value of depreciation based on historical data on the cost of construction and the cost of assets. The ATO will not accept cost of constructions based on published area rates, unless the Quantity surveyor uses them only as a guide. The rate of depreciation depends on either a self-assessment or an effective life determined by the tax commissioner. 

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