The Hidden Cash Flow In Investment Properties
Are you obtaining the full cash flow benefit of all allowable deductions against the income received from your investment property?
When things are tight an improved cash flow may be the difference between being able to maintain an investment property and having to sell up. Alternatively having an improved cash flow can enable a reduction in debt and save substantial interest costs over the term of an investment loan, potentially enabling you the investor to add further property to their portfolio sooner rather than later.
Often over looked when claiming deductions against rental income received from an investment property is the eligible deduction for depreciation under Division 43, Building Write-off Allowance and Division 40 Plant and Equipment Allowance. The Opteon Group have research which shows about 60% to 70% of all Australian property investors are not claiming their full entitlements pursuant to these two Divisions.
Assume the building value on an investment residential property was $200,000, if that property was built after 15 September 1987, the investor could be entitled to an annual depreciation claim under Division 43 of $5,000. An investor on the highest tax bracket rate of 47% could receive a tax saving of $2,350. On top of that every property would have some form of plant for which a depreciation claim could be made under Division 40.
It would appear that many accountants are not aware of the potential for these eligible deductions and their clients are therefore only claiming for “up keep” costs incurred during a relevant financial year. It seems that many accountants are either unaware of these Divisions or unsure of how they actually work. This may be because the Australian Taxation Office does not deem accountants as “appropriately qualified” to prepare these specific tax depreciation schedules due to lack of extensive construction knowledge.
From discussion with many “experts” within the property market, such as financiers, solicitors, and conveyancers, they also seem to be generally unaware of these Divisions and their potential cash flow benefits.
More often than not property investors only start claiming eligible deductions for depreciation once they incur the cost of replacement items, like that new hot water service or new carpet, or the cost of capital/structural improvements, like a renovated kitchen or bathroom. Little do they know that there may have been an allowance for the depreciation of the original construction costs or purchase price.
The capital out lay on an investment property is usually made up of three things, the land, the building and the plant and equipment, with each of these items being treated separately from a depreciation purpose.
Subject to the date construction commenced on a respective investment property these deductions may be claimed immediately against the capital outlay, excluding the land value and landscaping which is not depreciable.
The relevant construction commencement dates for Residential Buildings are as follows;
Before 1 July 1985 Depreciation rate: Nil
18 July 1985 – 15 September 1987 Depreciation rate: 4%
After 15 September 1987 Depreciation rate: 2.5%
There are different dates for the construction of external structural improvements, such as fences, gates, paving, and retaining walls, namely;
Before 27 February 1992 Depreciation rate: Nil
After 27 February 1992 Depreciation rate: 2.5%
Regardless of the date of construction, all investment properties have the ability to claim for depreciation under Division 40, Plant and Equipment Allowance. At the time of purchase of the investment property all plant items, such as carpets, ovens, cook tops, dishwashers, drapes, blinds, heaters and hot water systems can be valued by a Quantity Surveyor and given an effective life from the date of settlement.
When plant has been purchased for the sole purpose of generating rental income the cost/value can be written of over its effective life, as an eligible tax deduction. The “effective life” is the length of time it can be used for producing rental income. A financial assessment will need to be made between the potential value of the plant, and therefore the potential depreciable claim and the cost of having a Quantity Surveyor value the plant and prepare the subsequent depreciation schedule.
Should you not be claiming this eligible deduction as yet there is no need to despair as there is also an allowance in the legislation for lodging an amended assessment to account for the unclaimed depreciation for a period of up to 4 years. However if you have held an investment property for longer than a period of 4 years then every year counts and a Tax Depreciation Schedule should be obtained from a professional who is recognised by the Australian Taxation Office, as soon as possible.
A summary of how Division 40 and Division 43 apply in relation to the capital investment costs of a property investor and the ultimate cash flow improvement occurs is as follows, subject to the relevant construction commencement dates mentioned above;
As mentioned above the capital investment costs can be separated into three areas;
- Land value
- Building value, and
- Plant value.
Even though these costs are treated separately within the legislation they are normally grouped together within the purchase price or construction costs of a property.
Accordingly, the first requirement of a Quantity Surveyor is to establish the land value of the investment property and deduct that value from the capital outlay. Land is seen as a non-depreciating asset and therefore is not included in a tax depreciation schedule. Over time, land value typically increases.
The balance of the capital outlay is now eligible for a depreciation claim and all that is required is to separate the balance between, Division 43 Building Write-off Allowance and Division 40 Plant and Equipment Allowance.
The list of Division 40 items, being plant, is extensive and has been specified by the Australian Taxation Office, including the effective life of each of these items. It is through a property inspection that a list of these relevant items is established and based on quality and current status of each item that a value would be assigned to each. It is the experience in this area of the building industry that makes a Quantity Surveyor the most “appropriately qualified” professional.
These items will be divided into three areas, first year write off, being those items valued at less than $300, low value pool, being those items valued at more than $300 but less than $1,000 each item, and the balance. These three areas would be identified separately in the tax depreciation schedule.
The value of these items would be collated and deducted from the balance of the capital outlay. The remaining balance, by default, becomes the building value used when establishing the depreciation claim pursuant to Division 43.
On preparing the tax depreciation schedule there are two methods of depreciation can be used namely, diminishing value and prime costs, with the choice a method claimed being at the discretion of the property investor.