It can be difficult to navigate the minefield of tax laws that apply to property investors, and many might ask what the point is in claiming depreciation on a rental property if it will later affect the amount of capital gains tax (CGT) due.
Let’s look at some of the key questions that you might be asking as a new or potential property developer
1. What is CGT?
Capital gains tax was introduced in September 1985 as a way to tax any increase in value of an asset over the period for which you hold it. When you sell a property or other asset, this triggers a ‘CGT event’ where the following calculation is applied to calculate whether you have made a capital gain or loss:
CGT can get pretty complicated for investors, especially as each individual situation is different.
2. What is property depreciation?
Any wear and tear on a property and the plant and equipment items contained within can be classed as property depreciation. Owners of income-producing properties are allowed to claim a deduction in their annual tax return for any such depreciation, meaning a reduction in their overall tax bill. There are two main elements to property depreciation: capital works deductions and plant and equipment depreciation.
3. What is the impact of capital works deductions on CGT?
Capital works deductions apply to any wear and tear on the structure of the building, including items such as bricks, walls, floors, roofs, windows, tiles, and electrical cabling. Any capital works deductions you claim will reduce the cost base of the property, leading to an increase in your subsequent capital gain and any CGT due upon sale.
4. What is the impact of plant and equipment depreciation on CGT?
Any reduction in value on mechanical and easily removable plant and equipment assets held in an investment property can be claimed as a depreciation deduction. When you sell the property, calculations will be done on each item to determine whether a capital gain or loss has been made. The ATO states that if the termination value of your depreciating asset is greater than its cost, you have made a capital gain. If the reverse is true (i.e. it’s now worth less than you paid for it) you have made a capital loss.
5. What are the CGT exemptions for a principal place of residence?
If you own a property and live in it as your home, it will be exempt from CGT provided that it is used mainly for residential accommodation and is situated on land no more than two hectares in size.
If you choose to move out of your primary place of residence and rent it out, you will be eligible for a CGT exemption for a further six years, so long as you don’t own another primary place of residence.
There is currently nothing to stop you moving back into your property for a while and then moving out again, taking advantage of a new six-year CGT exemption as you rent it out. You could, in theory, keep repeating this as long as you were never absent for more than six years.
Only one property may be classed as a primary place of residence (and therefore exempt from CGT) at any one time. The only exception is if you treated two properties as your primary place of residence within a six-month period, in which case the following rules apply:
- the old property was your primary place of residence for a continuous period of at least three months in the 12 months before you sold it and you did not use the property to provide an assessable income in any part of the 12 months when it was not your primary place of residence
- the new property becomes your primary place of residence
6. Do property investors get a CGT discount?
Individuals or small business owners who own an investment property for over 12 months are eligible for a 50% CGT discount. The 12-month period is counted from the date the contract is signed to the date the property is sold.
7. Is there any benefit in claiming property depreciation if it will later increase the capital gain?
In short, yes. Any deductions you claim during the period of ownership will reduce your tax bill and free up some cash for you to use elsewhere.
When you come to sell the property, as long as you have held it in your name for over 12 months, the 50% exemption will apply. Any capital works deductions you have made during ownership will therefore have their impact halved when it comes to calculating CGT. You are likely to benefit more overall from the additional cash flow provided by claiming deductions during ownership than from paying your full tax bill but having a reduced CGT liability.
You should consult an accountant to understand the CGT implications on the sale of your investment property, while a quantity surveyor can advise you on the applicable depreciation deductions.