In our travels we come across misconceptions and ideas that have the potential to cause disruption to even the most well intentioned investment plan. In this article we’re going to generally discuss some thoughts on some of the more common mistakes and questions in the hope it will iron out some of the creases in your property investment knowledge.

“My property is too old for depreciation” or “What’s depreciation?”

Depreciation in relation to tax is the ability to write off the decline in value of an asset. With an investment property, this generally falls into two categories – the building component (Division 43 Capital Works) and the fixtures and fittings (Division 40 Plant and Equipment). The latter can be broken down further but for simplicity we won’t go any deeper for now. If your property was built after the 15th September, 1987 you are able to depreciate the construction cost at a rate of 2.5% per year for 40 years from the time of construction (not from when you bought it and not the purchase price). This means that if you bought a property in 2005 that was built in 1995 with a construction cost of $150,000, you will be eligible for a tax deduction of $3,750 p.a. until the year 2035 on the building cost alone.

The best part is that this is what is called a non-cash deduction meaning it’s money you didn’t have to spend every year (in theory you’ve spent it as part of the purchase price), so why wouldn’t you claim it as a tax deduction? The small catch is that for the total amount claimed reduces the cost base of the property for Capital Gains Tax (CGT) purposes upon sale of the asset. This is a small negative for a large positive however because due to inflationary pressures, your dollar is worth more today than it will be in say, 20 years, when you sell and that in most cases you’re also entitled to a 50% discount on the CGT payable if you hold the asset for greater than one year. This means you get 100% of the deduction but essentially only pay tax on 50% of the amount.

In addition, any improvements to the property that do not form part of the building that you add yourself after purchase can also be depreciated at a pre-determined rate and for an effective life, as set by the ATO. This means that if, for example, you install an air conditioner on a property built in any year, you are still able to depreciate that asset!

In short, there is no real reason you shouldn’t be claiming depreciation and maximising your cash flow through legitimate tax deductions. If you’ve been told your property is too old for depreciation, or you haven’t been told what it is, then it’s time to question your accountant. The best way to claim depreciation is to have a professional Quantity Surveyor complete a report that can simply be handed to your accountant at tax time (this is a one off cost).

 “Don’t buy an apartment because land appreciates and buildings depreciate”

This is a common one and something that isn’t correct for a range of reasons. In Hong Kong an average, 40m² one bedroom apartment – the size below which many banks in Australia will even lend for without heavy restrictions – is worth about $A1.25million in a 60-80 apartment block…and there are thousands of apartment blocks in Hong Kong. Prices are driven by supply and demand, and whilst land content is a factor in this, it is not a driver in isolation. Rather, land value is the key driver (not land content) in combination with the forces of supply and demand. There are plenty of examples where apartments will outperform houses depending on the market, the location and supply and demand at that time.

“I don’t need landlord insurance because I have building insurance”

People are generally quite aware that there is a need to insure any valuable asset against financial loss should an adverse event happen. When it comes to property investing, the cash flow on your property is the life blood that enables you to hold it over the long term whilst it grows in value. So it’s surprising that it is less common that people feel the need to insure against cash flow financial loss. This could be in the form of income protection, trauma cover or for property investors, a component of your landlord insurance.

Landlord insurance is generally made up of a number of types of cover within the same policy and is relatively cheap – only a few hundred dollars per year and is tax deductible. Maybe the most important part is that it will cover lost rent (past the bond amount) for a number of different situations e.g. your tenant simply stops paying rent, the property becomes unliveable due to a fire, flood etc.

What most people don’t plan for is that if this happens, your building insurance will not cover any rental loss whilst you recover the situation. Of course, having a lot of money in the bank will help this scenario, but why would you potentially fork out thousands of dollars when a few hundred dollars of insurance costs could alleviate this stress if the worst should happen? In addition, items such as blinds, carpets, light fittings and any accidental or even intentional damage the tenant causes whilst occupying your property will generally be covered by landlord insurance, but not by building insurance.

The bond will only cover so much and beyond that, it falls to the owner. If you don’t have landlord insurance you could find yourself out of pocket more than you budgeted for and very quickly. Not all policies are the same (in fact, some aren’t very good at all whilst some are excellent) so be sure to read the PDS thoroughly.

“I get it all back in tax”

Unfortunately, this is a concept that seems to rear its head over and over because of a lack of understanding of how the tax system actually works. When something is tax deductible, it means you pay for that item with pre-tax dollars, not post-tax dollars. Given that most people pay for things with income they receive from their PAYG salary, which has already been taxed, an adjustment is required at the end of the financial year to essentially reverse the situation. It is reversed by providing you back the portion of tax you shouldn’t have paid on the equivalent income amount that the item costs.

For example, if you earn $100 and your marginal tax rate is 30%, you will pay $30 in tax and keep $70. If you then buy something for $100 that is an allowable tax deduction, they reverse this by giving you back that $30 at tax time. The lesson here is that you are still $70 out of pocket for the item that costs $100! Even if you’re on the highest margin tax rate, you will still be out of pocket for just over 50% of the amount for any tax deductible item.

What this means is that higher income earners on the highest marginal tax rate derive a greater dollar benefit on the individual deduction. It should be noted though for fairness that the higher income earner will still pay a greater amount of net tax on the same rental income post deduction and that the benefit received versus the total net tax paid (on the investment income expressed as a percentage) actually decreases until the highest marginal tax rate is reached.

No matter what your income, even though you receive “tax assistance” to fund the item, you should still consider any expenditures carefully in the context of cash flow as it will affect your bottom line.

Stay tuned for the continuation of this article next month…

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