As a first-time property investor, I’m sure you’ve heard that tax depreciation deductions are typically one of the largest tax deductions you can claim as a property investor in Australia.
But it can be quite overwhelming navigating through the different claimable tax depreciation deductions.
For example, you may know that there are two different depreciation methods, but you aren’t sure if it’s best to use the diminishing value method or the prime cost method.
You know that there are several types of assets that you can claim depreciation deductions on, but are they capital works assets or are they classified as plant and equipment?
And, how is the effective life different for all these assets?
This article aims to help you navigate through all these questions and equip you with everything you need to know about a capital works deduction.
What Is Property Tax Depreciation?
Before delving into what a capital works deduction is, it’s important to understand property tax depreciation.
As a building gets older, its structure and the assets within the building are subject to general wear and tear. In other words, each year, the value decreases and thus, depreciates.
The Australian Tax Office (ATO) allows property investors, who generate income from their properties, to claim the depreciation as a tax deduction.
There are two types of depreciation deductions in the space of property investing, namely:
- Plant and Equipment: also known as Division 40, “plant and equipment” refers to the fixtures and fittings that are found within the building.These are generally known as easily removable assets and include items such as carpets and air conditioning units.
- Capital Works: this article will, primarily, be focusing on everything you need to know about a capital works deduction.
What Is a Capital Works Deduction?
Also referred to by the ATO as Division 43, capital works are income tax deductions that investors can claim from the wear and tear of the structural components of a property as well as items that are permanently fixed to the property.
The expenses incurred from any structural improvements made to your investment property, such as adding an extra room, for example, can also be claimed as a capital works deduction.
Who Can Claim a Capital Works Deduction?
Property investors who own income-producing properties are entitled to claim on a capital works deduction.
In other words, tax depreciation deductions are available for both residential investment properties as well as commercial buildings.
How Are Capital Works Deductions Calculated?
The percentage rate at which a building depreciates is dependent on:
- when construction commenced; and
- the intended use of the building (i.e. commercial or residential purposes)
Property investors who own residential properties built after 15 September 1987 are eligible to claim a capital works deduction at a percentage rate of 2.5% per annum over 40 years.
Where investors make structural improvements to residential properties after 27 February 1992, they can similarly claim a capital works deduction for the cost of construction at a rate of 2.5% per annum for 40 years from the date that construction completed.
In cases where the property is used for commercial purposes, a capital works deduction can be claimed at either 2.5% or 4% per annum depending on when construction commenced, the type of capital works and the nature of their use.
For example, commercial properties such as offices can be depreciated at a rate of 2.5% per annum if the construction commenced 15 September 1987.
But if construction commenced between 21 July 1982 and 15 September 1987, it can be depreciated at a rate of 2.5% or 4%.
Duo Tax has developed an easy guide to understanding property types and their applicable rates:
In January 2020, Carla purchased her first investment property for $410,000 and immediately rented it out.
Based on a report that she obtained from a Quantity Surveyor, the construction of the property commenced in January 2005 and was completed in October 2005. The cost of construction was estimated to be $290,000.
To determine the capital works deduction that she can claim in her tax return, she must use a depreciation rate of 2.5% as the construction of her residential property commenced after 15 September 1987.
The calculation is thus as follows:
$290,000 x 2.5% = $7,250
Carla rented out her property from 1 January 2020 to 30 April 2020, so she can only claim a deduction for 121 days of the year:
$7,250 x (121 days 366 days in 2020) = $2,397
So, Carla can claim a capital works deduction of $2,397 in her 2019-2020 tax return.
To determine the capital works deduction that Carla can claim in her 2020-21 tax return, the calculation is as follows:
$290,000 x 2.5% = $7,250
Carla rented out her property for a full year to her new tenants, so she can claim for the full 365 days a year:
$7,250 x (365 365) = $7,250
As the property was built in 2005, Carla can continue claiming capital works deductions until 2045, provided that she still owns the property and it’s being used to produce income.
What Assets Qualify for a Capital Works Deduction?
The following table provides a comprehensive list of assets that you can claim under capital works for both residential and commercial properties.
Capital Works Deductions on Construction Improvements
A property investor can claim the following construction expenses under a capital works deduction:
- building extensions such as adding a room or a deck;
- altering a building such as adding or removing an internal wall;
- structural improvements such as adding a carport or retaining wall.
Note: any expenses incurred before the construction such as architect fees, engineering fees, quantity surveyor fees as well as building permits all form part of the construction expenditure and can be claimed as a capital works deduction.
Capital Works Deductions That Don’t Qualify
Works completed that may seem like capital work in nature, may not always be depreciable. Items such as:
- Excavation and demolition of a tree on a block of land with no intended purpose to build over it
- Excavation costs for the installation of softscape features like plant and turfing, as these are non-perishable items
- Cost of plants and turfing cannot be depreciated however pots and retaining walls are permissible capital works items
As a property investor, knowing how to maximise the tax depreciation deductions that you claim will help you get the most out of your investment property.
The ATO outlines two categories of depreciating assets that you are eligible to claim as a property investor, namely:
- Division 43 – capital works deductions; and
- Division 40 – plant and equipment deductions
Capital works deductions are claimable on the depreciation of the structural elements of a building as well as the fixed items within the property.
As a property investor, you are also eligible to claim construction costs for improvements or alterations made to your income-producing property.
Depreciation on your investment property is a significant tax-deductible expense. In fact, it’s the second-largest tax deduction for your investment property after interest on your loan.
That is why it helps to purchase a tax depreciation schedule.
A tax depreciation schedule is a report that details the tax depreciation deductions you can claim on your investment property.
To maximise the benefits available to you, the deductions for the depreciation of your investment property must be accurately assessed by an expert quantity surveyor who specialises in tax depreciation.
At Duo Tax, our Quantity Surveyors are not only the very best agents but, most importantly, we’re a team of avid property investors who are keen to help other property investors save thousands of tax dollars every year.
To see if you qualify for capital works deductions, or to request a sample report, get in touch with us today!