[Updated June 2018 for new rules on plant and equipment depreciation] So you bought an investment property – good on ya. Now you need to know how depreciation works so you can pay less tax. This post provides a beginner’s guide to rental property depreciation in Australia, and will help you to manage your own finances and do your own tax return. A spreadsheet is also provided to help illustrate the concepts and do the sums for you, and you can freely download or copy the spreadsheet and use it to calculate your annual depreciation amounts.
Depreciation as explained to a 5 year old:
Say you buy a car on Gumtree today and then in a few years you sell it again – you’ll get less for the car because it’s older and has a bit more wear and tear (and a few more stains in the cushions). Your car’s decline in value over time is known as depreciation. The same goes for when you buy an investment property – the house and everything in it also depreciates according to the ATO. And the ATO lets you claim the amount of depreciation as a tax deduction every year, so you pay less tax – how good is that?
How depreciation works
When you buy an investment property, this is actually what you’re getting according to the ATO:
- Building (or Capital Works) – the house itself and everything that’s “permanently attached” to the house, like the doors and toilet
- Plant and Equipment – other stuff that came with the house that you could remove if you really wanted to, like the air conditioner and curtains
Land is not subject to depreciation, even if it’s worth less than what you bought it for (sucks to be you). However the building and plant/equipment always go down in value over time – this is what you claim as depreciation in your tax return.
According to the ATO, the building’s value decreases by 2.5% of the construction cost each year from the day it’s built. Unless your property started construction before 16 Sept 1987, in which case other rules apply. Every year the building depreciates, it’s worth a bit less, until it’s worth nothing in 40 years time (i.e. 2.5% per year x 40 years = 100%). Okay, so according to the ATO it’s worth nothing in 40 years time, but in reality it might still be a lovely house with some cool retro charm.
Plant and equipment depreciation
[June 2018 edit] – In 2017, the Government decided that it wasn’t too cool that people were buying used houses full of plant and equipment that a previous owner had already depreciated, yet the plant and equipment were being re-valued at wayyyy more than the closing value from the last owner. As a result, some items were perpetually being depreciated as houses got sold to new owners – as if those items suddenly got more valuable at each sale and were worthy of further depreciation. So now under the new rules, you don’t get to claim depreciation on second-hand plant and equipment in residential properties purchased after 9 May 2017. Just to be clear, you CAN still (continue to) claim plant/equipment depreciation on (a) investment properties you had before 9 May 2017 and (b) anything you buy brand new for your lucky tenants. If that’s you, read on…
The ATO gives you two options for calculating plant depreciation because they’re such nice guys. The fancy names of the 2 options are:
- Prime Cost (PC) method – where the item’s value is reduced by the same amount each year for the “effective life” of the item (after which it is worth zero, and you can’t depreciate it no more).
- For example, the ATO reckons an oven’s effective life is 12 years. So if your oven was worth $1200 when you bought the house, then each year it will depreciate by $1200/12 = $100.
- After 1 year, the oven is worth $1100
- After 2 years, the oven is worth $1000… you get the picture
- Diminishing Value (DV) method – where the item’s value is reduced by a fixed percentage each year, so every year its value becomes smaller, and smaller, and smaller, and smaller… (but technically never actually reaches zero).
- The percentage is calculated as “2/effective life” (or “1.5/effective life” if acquired before 10 May 2006).
- Let’s say our oven is pretty new-ish, so each year it depreciates by 2/12=16.7%.
- In the first year, our top-of-the-range oven depreciates by $1200 x 0.167 = $200, and is now worth $1200 – $200 = $1000
- In the second year, our slightly-less-valuable oven depreciates by $1000 x 0.167 = $167 and is now worth $1000 – $167 = $833… etc
The ATO publishes the effective life of pretty much anything you can think of associated with an investment property. Here’s where you get it.
Note that in the first year, you don’t get the full depreciation benefit unless you started renting out your house on 1 July – the first day of the financial year. Otherwise you have to do a pro-rata calculation to work out how much depreciation you can claim in the first year, i.e. multiply the full year depreciation amount by the number-of-days-owned/number-of-days-in-the-year.
A lot of people want to get the biggest tax deduction as soon as possible – in that case, the DV method is better because it lets you claim more at the beginning, but less later on (as illustrated by the oven example above). However there are times when you may want to spread the depreciation out a bit more, so you can claim more later on. For example, say you bought a house to live in yourself, but after a few years you decide to move to Bali (why not?) and rent out your house. While you live in the house, it is still depreciating but that depreciation isn’t tax deductible. However when you rent it out, you can start claiming the depreciation. In this case, the PC method may let you claim a bigger deduction from when your house becomes an investment.
Some notes about plant depreciation:
- If you dispose of an item of plant, you can claim whatever value it has left as a deduction (minus any money you made out of it by selling it on Gumtree or whatever). For more info, check out this page from the ATO.
- Once you’ve started using the PC or DV method for a property, you can’t change your mind later on. So choose wisely.
- In MyTax, the depreciation amount for Plant and Equipment goes in the field labelled “Total capital allowances” (this was Item I of the Rental Property Schedule, back in the day, but now apparently they don’t like letters anymore)
Low Value Pool – for cheap items
The ATO knows that it can be a pain to manage the depreciation of plant items, especially when you have a lot of items (hey, maybe you’re a hoarder). So they make it a lot easier to depreciate items that aren’t worth a lot. For any items worth less than $1000, you can put them in a thing called a “Low Value Pool”, which depreciates at a fixed 37.5% each year. Except for the first year, in which case it depreciates by half that amount: 18.75% (you don’t have to do any complex pro-rata calculations). Simple huh?
If you acquired an oven worth $900, and a cooktop worth $900 – you can chuck them both in the LVP. Both items are what the ATO call “low-cost assets”. The total value of the LVP starts at $1800.
- In the first year, your LVP depreciates by $1800 x 0.1875 = $337.50 and is now worth $1462.50
- In the second year, your LVP depreciates by $1462.50 x 0.375 = $548.44 and is now worth $914.06… etc
Some notes about LVPs:
- Just think of the LVP as a total value – you don’t really need to care about the individual items, or what each item is worth at any given point in time. It’s just a whole bunch of miscellaneous stuff that is worth less by 37.5% every year.
- The only time you’ll need to care about a specific item in the LVP is when you dispose of it. If you have an oven in the LVP and sell it for $200 as part of a kitchen renovation, then you reduce the value of the LVP by $200.
- However if the oven has carked it and is now worth $0, there is no impact to the LVP. You don’t get to claim any remaining value on the now-worthless oven, but you do still claim depreciation from the LVP as if the oven was still in it! That may seem weird, but it’s just keeping things simple.
- Once you start a LVP, then any future items you acquire worth less than $1000 must go into the LVP.
- You only have one LVP, even if you have several investment properties
- When you add a new item to an existing LVP, that new item depreciates by (you guessed it) 18.75% in the first year, while the rest of the pool depreciates by 37.5%. Then in the next year, it joins in the party and depreciates by the full (you guessed it, again!) 37.5%.
Low value assets:
Say you acquired an oven initially worth $2000, so you depreciated it using the DV method. After a few years of depreciation, that now-not-so-swish oven drops to below $1000 in value. In the year where this happens, you’re allowed to move said oven into the LVP (using ATO lingo, the oven is now a “low-value asset”). This usually allows items to depreciate faster, which means you get a bigger tax deduction sooner. But you can only do this if it was previously depreciated using the DV method. So many rules, huh?
Immediate deduction – for really cheap items
For any items worth less than $300, the ATO lets you tax deduct the full value in the first year – woo hoo!
What else do I need to know?
- Depreciation is the only investment property deduction that lets you reduce your tax without actually paying anything out of pocket. If you need to fix the plumbing in your investment property, that cost is tax deductible but you still have to pay the plumber with actual money that you could have used to buy yourself a really nice sandwich. But with depreciation, you can reduce your taxable income without actually spending any money.
- The value of the land, building and plant items can only be assessed by a person known as a quantity surveyor. You’re not allowed to just give it your best guess, unfortunately. The quantity surveyor will check out your property and give you a report called a “depreciation schedule” that has all the info you need. Note: it might cost you somewhere around $250-$600 but that’s tax deductible. Just Google “depreciation schedule Perth” or similar and you’ll be on your way.
- Claiming depreciation reduces your annual tax liability, but you’ll end up paying more Capital Gains Tax later if and when you decide to sell. Check out our article on CGT to understand how the reduced building and plant values increases your capital gain. Even though you might pay more tax later (only if you sell) you do get a nice 50% capital gains tax discount (for investment properties you’ve owned for over 1 year) and for a lot of people, it’s better to have the tax break now so you can invest the savings, or use it to buy more video games.
- For more information, go directly to the depreciation section on the ATO’s website, which discusses all business deductions (not just investment properties). They also discuss depreciation in their information-dense Rental Properties Guide. The ATO publish the official rules, which means they have to use unambiguous language (nice one, lawyers) and explain every possible scenario (even those that don’t apply to most people) so be prepared. However they do provide some nice examples that help to clarify the rules and make them easier to understand.
Depreciate like a boss
You’re still reading? Sweet.
Now that you know the theory, if you want to see how depreciation works in practice, a great way is to put it in a spreadsheet. Here’s a spreadsheet with some example data in it that you can modify for your own purposes.
Some notes about the spreadsheet:
- It’s free and unprotected – download or copy it, then edit it as much as you want – add new rows, modify the fields, go crazy
- The first tab is the PC method, the second tab is the DV method
- If you want to use the spreadsheet to calculate your own depreciation:
- Replace all the blue example data with info from your depreciation schedule
- The most important values you need are highlighted in bright yellow (plus a note on where to put those values in your tax return)
- In the first financial year, you’ll need to determine how many days your investment property was available for rent all by yourself. Get out a pen and paper, it’s character building.
- The spreadsheet helps you to manage changes over time – when you dispose of items or purchase new items. The “air conditioner” is shown as an example.
- It should be pretty intuitive, but please let me know if you have any comments (below) or by email.
- The spreadsheet is provided for “illustrative and educational” purposes only.
MyTax also has a good depreciation tool that lets you put in all your building and plant items and their values and it will work out how much depreciation you can claim each year (but unlike the spreadsheet, it doesn’t actually show you how the values were calculated). However you don’t need to use the MyTax depreciation tool – you can calculate depreciation yourself and just insert the final depreciation claims in the appropriate fields in your tax return. Or if you’re feeling lazy, get your accountant to do it… but where’s the fun in that?
Final note: This beginner’s guide to rental property depreciation is considered general advice only with limited entertainment value. It is not financial advice and I do not sell financial products. I also don’t discuss every little detail or every possible scenario that may apply to you. If you have any comments or suggestions, please do let me know by email or in the comments below.