How do you Benefit from Depreciation?

Capture Your Full Benefits

IF YOU ASK commercial property investors about tax benefits, their first thoughts probably turn to negative gearing.

Sadly, most investors don’t spend a lot of time actually thinking about Depreciation and how it works.

However, they quickly discover it improves the bottom line – and therefore, your overall return from the property.

You see, the purpose of depreciation is to compensate investors for the decline in value of their depreciating property assets (plant and equipment) … as well as the wear and tear of the building itself.

How does this work in practice?

The underlying assumption here is that your building and its fixtures will decrease in value as they become older – while the land and overall value of the property increases over time.

The Australian Tax Office is happy to compensate you for wear and tear; but it won’t agree to tax deductions, for a decline in value that does NOT occur!

And you can happily take advantage of the provisions right up until you sell your property.

At which point, you’re required to calculate what decline in value has actually occurred. And if you happen to have deducted more than the actual decline, then you effectively have to pay back that amount to the ATO.

However, the good news is … you’ll be doing so in tomorrow’s dollars.

Look at it this way: You buy a million-dollar property today, and hold it for 10 years.

Over that period, you may have total depreciation of $400,000. This allows you to reduce your assessable income during the 10 years – giving you an actual saving of $400,000 multiplied by your marginal tax rate, say 45% … equating to $180,000.

Let’s say that after 10 years, you sell the property for $3 million, you will have a capital gains tax liability on the profit from the land and buildings; and a potential balancing adjustment for the depreciating assets.

Although most unlikely … even if you end up having to pay back the entire $180,000 … you would do so from the proceeds of the sale (in tomorrow’s dollars) AND you will have already enjoyed the cash-flow advantage of the tax savings, while you owned the property.

If your marginal tax rate falls, you will be in an even better position on disposal. Not to mention that $180,000 now is worth a whole lot less than the $180,000 the tax savings you have already gained, over the past 10 years!

While this is unlikely … as long as you are aware of the potential consequences on disposal, you can plan for it; and there will be no surprises.

Plus, having the benefit of depreciation in the early years will means your investment works harder for you – making your after-tax yield look surprisingly healthy.

Depreciation when you Acquire a Property

As you now understand, the aim of tax depreciation is to compensate taxpayers for the decline in value of depreciating assets and buildings.

Depreciation of plant and equipment is referenced in division 40 and 42 of the Income Tax Assessment Act Of 1997. Whereas, structural depreciation (also know as capital works deduction or special building write off) is referred to in division 43 of the Act.

The underlying assumption of depreciation is that your property and its components will decrease in value over time. However, you and the property market may have other ideas!

What difference will Depreciation make?

The total depreciation available for the early years of owning a property can make a huge difference to your after-tax cash flow.

Let’s consider an example of the purchase of a $5 million office building with a land value of $1.5 million.

It was built in 2008 for $3 million, with a typical ratio of 30% of the original building value being plant and equipment – equating to around $900,000. Meaning the structural component was $2.1 m.

The first thing a quality surveyor does (when you purchase a property) is deduct the value of the land – in this case $1,500,000 … to arrive at the value of the property’s various building components – being $3.5 million.

Under the ATO guidelines, the quantity surveyor then establishes the value of the Structural aspects of the building – based upon the cost of construction in 2008 – to arrive at a figure of $2,100,000.

Therefore, by subtraction, the current day value of the Plant & Equipment equates to $1,400,000. And this is the figure you get to depreciate.

You will recall that the original cost of the Plant & Equipment would have been only $900,000 back in 2008. However, you are able to up-value these items – because their ultimate value is set by the current contract price for the property.

You see, the value of the land is generally established by using the site value on your rate notice. And the value of the structural component by construction costs in 2008.

Therefore, by simple arithmetic … the balance is then attributed to Plant & Equipment – which you then get to depreciate.

On these figures, you could be entitled to claim the following depreciation during the first two full years of your ownership.

That would give you a combined total claim of $595,000.

However, there is a Proviso

You need to ensure that the Contract of Sale is what’s called “silent” – as far as attributing any value to the Plant & Equipment. In other words, the contract does not contain any special conditions relating to the written-down value of these items – by the vendor.

Otherwise, you would be obliged to only claim further depreciation based upon that written-down value figure.

Fortunately, most sellers neglect to include such a clause.

However, this also identifies the way in which you can minimise any clawback by the Tax Office, when the time comes for you to sell.

All you need do is include a schedule of written-down values for your Plant & Equipment – and thereby, avoid any potential for a balancing charge being levied after settlement occurs, when you sell the property.

Upgrading or Renovating?

If so … you will probably be getting rid of old fixtures & fittings, partitions and walls – sometimes whole rooms and other assets currently being depreciated – which would give rise to an immediate write off.

As such, you’ll benefit from an deduction equivalent to the written-down value of these assets. And this is true for both plant & equipment; plus any structural alterations you may also make.

A Quantity Surveyor can help calculate the scrap value of the assets that have been disposed of … ensuring you continue to depreciate the remaining assets, as well as claiming your immediate write-off.

With these newly-installed assets, the principles for depreciation remain the same. You also have extra deductions available, if you incur capital expenditure to improve your property.

Things like consultants fees and other preliminary costs can also be apportioned over assets, and depreciated accordingly.

Want to Learn more?

To make sure you have a full understanding of what’s involved … Bradley Beer and I have put together short report – which should help to fill in any gaps.

I realise all this may seem rather technical – but don’t worry about that.

You simply need to engage BMT Tax Depreciation to handle everything. They provide you with a detailed Tax Depreciation Schedule to give to your accountant – who is the one making the actual claim on your behalf.

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