When you own an investment property, you’ll often hear about a “depreciation expense”, but what does that actually mean? Put simply, a depreciation expense refers to the amount you claim as a tax deduction each year for the wear and tear of your property’s assets over time.
While it’s not a direct out-of-pocket expense like repairs or council rates, depreciation expense can still significantly reduce your taxable income and increase your overall return on investment.
In this guide, we’ll explain exactly what a depreciation expense is, how it’s calculated, and why understanding it can be key to maximising your property investment’s financial performance.
What is a Property Depreciation Expense?
A property depreciation expense is a tax deduction that property investors claim each year to account for the natural wear and tear or decline in value of their investment property over time.
When you own a rental property, things like carpets, appliances, blinds, and even the building itself gradually lose value as they age. The Australian Taxation Office (ATO) allows investors to claim this loss in value as an expense, even though it’s not a direct cash payment.
In other words, unlike expenses such as insurance or repairs, depreciation is a “non-cash expense.” You don’t physically spend money each year, but you still get to claim this expense on your tax return, which reduces taxable income, essentially lowering the amount of tax you pay.
What are the Different Types of Property Depreciation Expenses?
There are two main categories of depreciation expenses:
- Capital Works (Division 43): deductions on the property’s structural components, like the building itself, claimed at a fixed annual rate over a 40-year period.
- Plant and Equipment (Division 40): deductions for removable assets inside the property (appliances, carpets, fixtures, etc.), each with its own effective life determined by the ATO.
How Do You Calculate Depreciation?
Calculating depreciation depends on the type of asset you’re claiming. The two main methods property investors use are:
1. Prime Cost Method
This method (also called the straight-line depreciation method) spreads depreciation deductions evenly over the asset’s effective life.
Example:
You install an air conditioning unit in your rental property for $2,000. The ATO sets its effective life at 10 years.
- Depreciation per year = $2,000 ÷ 10 years
- Annual depreciation = $200 per year for 10 years
2. Diminishing Value Method
With this method (also called the declining balance depreciation), deductions are highest in the first few years and gradually decrease over time. It’s calculated using a higher percentage on the asset’s remaining value each year.
The formula is:
- Asset’s cost × (Days held ÷ 365) × (200% ÷ Effective life)
Example:
Using the same air conditioner valued at $2,000 with a 10-year effective life:
- First year: $2,000 × (365 ÷ 365) × (200% ÷ 10) = $400 deduction
- Second year: ($2,000 – $400) × 20% = $320 deduction
- Third year: ($1,600 – $320) × 20% = $256 deduction
The diminishing value method provides larger deductions upfront, making it popular with investors looking to maximise their immediate cash flow.
Which Method Should You Choose?
- Prime Cost suits investors preferring stable, predictable deductions each year.
- Diminishing Value suits investors wanting accelerated depreciation deductions to improve immediate cash flow.
A professional depreciation schedule prepared by a Quantity Surveyor usually includes both methods, clearly showing which one gives you the best deductions based on your circumstances.
So, How Does Claiming Depreciation Work?
To claim depreciation, you need to order a depreciation schedule from a qualified Quantity Surveyor that outlines the following components:
- The original cost of your investment property, including any renovation or improvement costs
- The useful lifespan (also known as the effective life) of your fixtures and fittings as determined by the ATO
- How much the structural components of your property and its fixtures and fittings have already accumulated depreciation and will continue to depreciate
- Depreciation calculations based on your preferred method (prime cost or diminishing value)
Once you have your depreciation schedule, either you or your accountant must submit it with your annual income tax return. The ATO will then reduce your taxable income by the amount specified on your depreciation schedule.
Example
Let’s say you purchase a brand-new townhouse for $720,000 and decide to rent it out six months after purchasing it.
You charge your tenants a weekly rental of $540, generating an annual income of $28,080. All your property expenses, including mortgage repayments, maintenance expenses, rates, and taxes, amount to $38,522.
After contacting a Duo Tax Quantity Surveyor, you find out that you can claim deductions for the property’s capital works deductions. Unfortunately, because you lived in the property for a short period, your plant and equipment assets are classified as “second-hand” or “existing” assets, and you no longer qualify to claim a depreciation deduction.
However, if you install any new fixtures and fittings, you can get your Quantity Surveyor to update your depreciation schedule.
Based on the above information (and without considering any other tax deductions), your depreciation claim adds up to $9,000:
Annual Income $28,080 Annual Expenses $38,522 Net Income (pre-tax) (Income minus expenses: $28,080 – $38,522) -$10,442 Total Tax Loss [net income + depreciation: (-$10,442) + ($9,000)] -$19,422 Tax Refund (tax loss x 37% tax rate) $7,194 Annual Cost -$3,248 Now, when you’re running at a loss (i.e. your property is negatively geared), you qualify for a tax refund. Depreciation is technically a loss, too, so it boosts your tax refund – essentially reducing the amount of tax you pay.
Without the depreciation boost, your refund would’ve only amounted to $3,864.
This was a simple illustration, but remember that various factors can affect your depreciation claim. We have a case study section showcasing how different scenarios can increase your tax refund!
Depreciation for Renovations and Improvements
When renovating or upgrading your investment property, it’s important to understand how these changes affect depreciation claims.
Repairs vs Capital Improvements: What’s the Difference?
- Repairs maintain or restore the property’s original condition. Examples include repainting walls, fixing leaks, or patching holes. You can usually claim the full cost immediately as a tax deduction in the year you incur the expense.
- Capital Improvements enhance your property’s value, function, or lifespan. Examples include major renovations like kitchen upgrades, new flooring, or adding extra rooms. These improvements can’t be immediately deducted—instead, they must be depreciated gradually over their effective life.
Updating Your Depreciation Schedule after Renovations
Any capital improvements should trigger an update to your depreciation schedule. Engage your quantity surveyor after completing renovations to ensure your schedule is accurate and reflects all newly depreciable assets, maximising your future deductions.
The Role of Quantity Surveyors in Property Depreciation
A quantity surveyor is a professional qualified to estimate construction costs and assess property depreciation. Their role is crucial when it comes to accurately working out depreciation expenses for your investment property.
- Inspect your property to identify all depreciable assets and structural components.
- Accurately determine the effective life and depreciation rate for each asset.
- Produce an ATO-compliant depreciation schedule outlining your deductions for each financial year.
Why Engage a Quantity Surveyor?
- Accuracy and Maximised Claims: They know exactly what you can legally claim and ensure you don’t miss out on deductions.
- ATO Compliance: A professionally prepared depreciation schedule reduces your risk of errors and provides reliable documentation in the event of an audit.
- Long-Term Value: Although there’s a cost involved, the tax savings typically far outweigh the fee—which itself is tax-deductible.
Key Takeaways
- In conclusion, yes, depreciation is an expense (albeit a non-cash expense), which is why the ATO allows you, as an investor, to offset it against the income you generate from your rental property.
- The more you can deduct from your income, the less overall tax you pay.
- So, with depreciation being the second largest tax deduction available to property investors (after interest on your mortgage repayments), you must take advantage of the significant savings it can bring you each year.
- As we mentioned earlier in this post, only a qualified Quantity Surveyor can prepare a depreciation schedule that you can submit with your tax return.
- At Duo Tax Quantity Surveyors, we are proud to offer the best service for property investors looking to maximise their depreciation claims. With over 30 years of experience, our team of experts is knowledgeable and skilled in all aspects of property depreciation.
- Our goal is to provide our clients with comprehensive, accurate, and competitively priced depreciation reports that are compliant with the ATO regulations. We believe in providing personalised and professional service and working closely with each client to understand their specific needs and goals.
- Our focus on customer satisfaction and our commitment to providing the best service possible is what sets us apart and makes us the top choice for property investors across Australia. We are confident in our ability to help you maximise your depreciation benefits and achieve your investment goals.
Contact Us Today For a Depreciation Schedule Today
If you want to learn more about how depreciation works or if your property qualifies for a claim, contact us today.
Frequently Asked Questions (FAQs)
How Often Should I Update My Depreciation Schedule?
You should update your depreciation schedule whenever you carry out significant renovations, improvements, or replacements on your investment property. If no major changes have occurred, a quality depreciation schedule typically lasts for several years.
What Happens to My Depreciation if I Sell My Property?
If you sell your property, depreciation deductions can impact your capital gains tax (CGT). Specifically, the depreciation you’ve claimed for capital works (the building structure) is subtracted from your property’s cost base, potentially increasing your taxable capital gain. Always seek professional tax advice when planning to sell.
Can Claiming Depreciation Help Me Negatively Gear My Property?
Yes, depreciation deductions reduce your property’s taxable income, potentially increasing your loss and creating negative gearing benefits. This can lower your overall taxable income, resulting in significant tax savings.
How Does the Annual Depreciation Expense Appear on My Income Statement?
Your annual depreciation expense shows up on your property’s income statement as an expense item, reducing your taxable rental income. Although depreciation isn’t an actual cash outlay, it decreases your property’s net income, helping to lower the overall tax you pay.
Can I Depreciate All Types of Assets in My Rental Property, Including Capital Assets?
Yes. Depreciation applies specifically to capital assets—assets you own and use over multiple years, such as buildings, fixtures, appliances, or furniture. These capital assets must have a determinable useful life and gradually decline in value over time.
What’s the Difference Between Straight-Line Depreciation and Double Declining Balance Depreciation?
The straight-line method spreads your unit depreciation expense evenly over the asset’s life. In contrast, the double declining balance method is a more accelerated depreciation approach that applies a higher depreciation rate (usually double the straight-line rate) to the asset’s remaining value each year, giving you larger tax deductions early on.
For investment properties in Australia, the standard method similar to double declining balance is known as the diminishing value method.
What is the Salvage Value of an Asset?
The salvage value (also called residual value) is the estimated amount you expect an asset to be worth at the end of its useful life, after it’s fully depreciated.
In other words, it’s the approximate value you believe you could sell or scrap the asset for when you’re done using it.
