Explanation on how depreciation

Although I've been hearing that depreciation can be helpful for IP cashflow, I don't exactly understand how it works.

Could someone please explain it in plain English as I'm not a tax expert as well? Or if you don't mind, a diagram perhaps?

 

Many items, such as the building component of an IP depreciate. That is, the construction materials drop in value over time, because they fall apart. Eventually you will either have to repair the building or replace it.

In recognition of this, the tax office allows you to write of the value of the building and many other times over time. Buildings can generally be written off over 40 years, so you get to claim a drop of 2.5% of the building value every year (since it was built I think).

Say the building is worth $400k, you get to write off $10,000 a year ($400k x 2.5% = $10k)

Now let's assume your normal taxable income is $100,000. You'd pay about $24,947 in income tax.

The $10k of depreciation you can claim makes your new taxable income $90,000. You should have paid $21,247 in tax.

You get a refund of the difference ($24,947 - $21,247) which is $3,700.

Your annual cash flow has increased by $3,700 because you own a building that drops in value over time.

* I'm no accountant and I'm not certain of the figures, or if the methodology is 100% accurate, but this is my laymans understanding of how it works.

** There's additional depreciation available for lots of other things in the property, a lot of it on shorter schedules than 40 years. That's why you should get a depreciation report to make sure you cover it all.

 

Ooo I see... Now I get it.. Thanks Peter

 

The effectiveness of a depreciation schedule does depend on the age of the property.

For a new 3/2/2 expect around $12k of depreciation in the first year sliding down to around $9k after 5 years.

Recently renovations can be depreciated. The IP I just bought in qld had extensive works done, including an additional garage. The outcome is $6k in the first year sliding down to $5k in the fifth year. This is despite the original property perhaps being built in the 60's.

Either way an effective boost to your tax deductions.

 

However ms puss in boots - there is cgt implications,

 

CGT is a boogeyman that a lot of people like to raise in conversations about depreciation. It's worth considering but, to shine a torch under the bed, here's something I wrote to someone the other day (please excuse the copy/paste job):

CGT is a complex issue and everyone's situation varies so it's important to have good accountant advice. Our experience shows that fears of this nature are generally unfounded for a few reasons:

* Only part of the depreciation claim is used to calculate CGT. This is the capital works portion. Therefore, the age of the property and its level of renovation should be taken into account. Older and/or unrenovated properties will have few capital works deductions and hence a smaller effect on CGT.

* The ATO assumes depreciation has been claimed when applying CGT. You can demonstrate to them that you haven't, of course, but in situations where a build cost is known they can force you to apply it anyway.

* Owning a property for more than a year gives you a 50% discount on CGT. There is no similar reduction to depreciation deductions! The gain from claiming depreciation is usually greater than the additional loss incurred by factoring it in to CGT.

* Taking this into account and, as you say, cash flow being helped by depreciation claims, the benefits to having the money in your hand now seem obvious to us. This is as opposed to banking on future plans that may or may not come to pass. For example, what if the property ends up not being sold? What if capital gain is lower than expected? In both of those scenarios the investor would feel quite sheepish if they didn't claim depreciation when they could have done so (and there's only so far back you can amend your previous tax returns). The old saying comes to mind: a bird in the hand is worth two in the bush.

Again, everyone's situation varies, so proper accounting advice needs to be sought. However, that advice cannot be given on a simple assumption. Numbers, including a depreciation estimate (always free from us), need to be crunched.