Depreciation Schedules and Property Investing

Ok let's get down to some investment basics!

Negative gearing is something you hear a lot when people talk about investing in property. It is in fact a key factor in the wealth creation strategies of serious property investors.

In affect it is the government saying to investors we acknowledge that you are taking a risk and we will compensate you for the fact that you are developing an income from property.
Now that is not the technical definition but it is a layman's description!

You are building a property and that property, bricks and mortar loses value over time. Why? Well it can wear out; lose its newness, what is called depreciation!

The house/unit is therefore referred to as a depreciating asset (see definitions). The land on the other hand cannot be claimed as such, in fact it is the land portion of the investment that generally gains in value or appreciates. This is the key in property investing the land appreciates and the building depreciates and these two factors work together to make ownership more cost effective!

Now if you buy a second hand run down property your costs to maintain and even repair can be quite substantial and will bite into any rental income quite savagely!
This is why you would be encouraged to invest in new property when you first start out. The new property will achieve the maximum level of depreciation and at the same time cost you very little in repairs etc.

The initial repairs and improvements are deductible but only over 25 to 40 years - this will not help your cash flow and remember we are trying to maximise our investment dollar!

Next time I will discuss the other ongoing costs that are claimable as an expense in your property investing portfolio.

Definitions
A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used.

Ok having discussed what negative gearing is let's look at the practical aspects.
How do I use this to assist my investment activity in this property I have bought for wealth creation?

Well to begin with recall what we discussed last time. The building is a depreciating asset - it loses value over time and that loss can be determined and claimed against taxable income. In affect the loss is covered by tax you will pay or are paying - not cash from your pocket! In effect the tax you would have paid is now being invested into the property - you are sort of compensated for the loss on the money you borrowed to build that property!
Now before you start you need a clear statement of the actual depreciation - a Depreciation Schedule(DS). This is like a spread sheet setting out the initial values of the property and then the estimated losses in value over time - that time being 25 or 40 years depending on which you choose.The DS provides the tax office with a picture of the property and the schedule would list fixtures that could be depreciated. The schedule is prepared by a Quantity Surveyor not your mate who sells little bit of real estate!

There a number of sections to the system and I will discuss these.

CAPITAL WORKS: Division 43 Allowances

Capital works deductions are based on the construction costs associated with the building. This is the physical cost that went into the construction and can include clearing the site, soft landscaping etc. For property built in Australia after 1987 it provides a tax deduction of 2.5% of the initial cost per year, on a Prime Cost basis over the first 40 years of its life!

Division 40 Allowances

Now as you will appreciate already the way things wear out is actually different for each type of material. Some materials need to be written off more quickly eg ovens, hot water cylinders, carpets, drapes and furniture. These fall under Division 40 Allowances in Australia.

Low Value Pool and Immediate Write Off
Within the Division 40 Allowances there is scope to add some items to a low value pool and to write others off immediately. Items valued between $300 and $1000 can be depreciated at a faster rate using the diminishing value method. Items under $300 are able to written off immediately using both the prime cost and diminishing value methods.

DEFINITIONS

The diminishing value method
The diminishing value method assumes that the decline in value each year is a constant proportion of the remaining value and produces a progressively smaller decline over time.

The prime cost method
The prime cost method assumes that the value of a depreciating asset decreases uniformly over its effective life.

Here is the first part of a Prime Cost 40 Year Summary.

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Capital Expenditure Incurred On PLant and Articles

Year $ Plant: $Capital $ Total
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1 547 1100 1647
2 1168 2347 3515
3 1168 2347 3515
4 1168 2347 3515
5 1168 2347 3515
6 1111 2347 3458
7 1033 2347 3380

The first year is what you can claim in your first financial year of ownership (or part thereof).

Then the following years are listed up to Year 40. Your accountant will know exactly what to do with such a table and as always seek professional advice once you have your schedule.