In this follow on from Part One in our series Understanding tax and property investment we look at depreciation of investment properties as well as Capital Gains Tax.

Depreciation for deductions

Each year the tax office issues an effective lives schedule for the purpose of calculating the depreciation of plant and equipment.

Just as companies receive tax deductions for the depreciation of assets used to produce income, property investors can also claim for depreciation of building and internal items.

A deduction is allowable to the extent that your rental property is used for a taxable purposes. For a rental property, the taxable purpose is producing rental income. Investors can work out the deduction for the decline in value of a depreciating asset by using either the prime cost or diminishing value method. Both methods are calculated using the effective life of the asset.

Prime cost

Prime cost assumes that the value of a depreciating asset declines in value evenly over the course of its effective life.

Asset’s cost x (days held / 365) x (100% / asset’s effective life)

Diminishing value

The diminishing value method of depreciation assumes that the decline in value each year is a constant proportion of the remaining value which produces a progressively smaller decline over time.

Base value x (days held / 365) x (150% / asset’s effective life)

Regardless of the method used, the decline in value of an asset cannot be more than its base value in any year. Further, if you use a depreciating asset for any other purpose other than exclusively at the rental property (for example a lawn mower used both at home and at the rental property), you must apportion the allowable deduction based on the percentage of use of the asset at the rental property.

Effective lives (Division 40)

The effective life of an asset is how long it can be used by an entity for a taxable or income producing purpose. It is expressed in years.

For example if a company bought a boardroom table for $1,000 which had an effective life of 10 years, then using the prime cost method the table would decline in value by $100 per year creating a tax deduction of the same for each year.

Each year the tax office issues a set of tables outlining the effective lives (depreciation rates) for common assets. Effective lives are considered:

  • having regard to the wear and tear you would reasonably expect from your expected circumstances of use
  • assuming that it will be maintained in reasonably good condition or order under expected activities of use
  • having regard to the period within which it is likely to be thrown away, sold for a small value or passed along.

Replacement

An immediate deduction can be claimed for depreciating assets costing $300 or less which are used to produce rental income if certain conditions are met. Alternatively you may depreciate assets costing less than $1,000 through a low-value pool (low- value pooling items).

Immediate deductions

An immediate deduction is available if the following conditions are met:

  • the asset cost $300 or less
  • it is used mainly for the purpose of producing rental income
  • it is not part of assets you start to hold in the income year that costs more than $300
  • it is not one of a number of similar items (part of a set) which cost more than $300 in total.

Low value pooling items

You can allocate low-cost or low-value items which relate to producing rental income to your low-value pool.

A low-cost asset is a depreciating asset whose cost is less than $1,000 at the end of the income year in which you start to use it.

A low-value asset is a depreciating asset that is not a low-cost asset and:

  • has an opening adjustable value for the current year of less than $1,000
  • which you have worked out any available deductions for decline in value under the diminishing value method.

Once you’ve established a low-value pool and have allocated assets to that pool, you must pool all other assets you start to hold in that income year. An item remains in the pool once it has been allocated.

Only one calculation for the decline of depreciating assets in the pool is necessary.

When you allocate a low-cost asset to the pool you can calculate its decline in value at a rate of 18.75%.

You work out the deduction for the decline in value of the low- value pool using a diminishing value rate of 37.5% (i.e. a new item is depreciated by 18.75% in the first year and 37.5% thereafter).

Depreciation of assets using diminishing value example
Items Cost of the asset Base value Days held/365 150%/effective life Deduction for decline in value Adjustment value
Lounge $2,000 $2,000 300/365 150%/10 years $257 $1753
Carpet $3,000 $3,000 300/365 150%/12 years $308 $2,692
Air conditioning $1,500 $1,500 300/365 150%/7 years $264 $1,236
Depreciation for low-value pool example
Items  Percentage of cost or adjustable value Low value pool rate  Deduction for decline in value Closing pool value
Low-value assets
Pool $2,500 37.5% $938 $1,562
Low-cost assets
Microwave oven $450
Television $750
Total low cost assets $1,200 18.75% $225 $975
Total deductions for year end $1,163
Total pool value for year end $2,537

Capital works deductions (Division 43)

Building a house on a piece of land is considered improvement. The tax office tells us that a house (or rental property) has an effective life of 25 or 40 years, depending on when it was constructed. Deductions for the depreciation of such are called capital works deductions.

Capital works deductions can’t exceed the construction expenditure, and you can’t claim a deduction until the construction is complete.

However, you may be able to claim interest costs associated with financing construction costs during the construction period.

Capital works expenditure applies to work such as:

  • a building or extension
  • alterations or major renovations
  • structural improvements to the property.

The amount of the deduction and how it is calculated depends on the type of construction and the date construction started.

Date construction started Rate of deduction per year Number of years for deduction
Before 22 August 1979 Nil n/a
22 August 1979 to 21 August 1984 2.5% 40 years
22 August 1984 to 15 September 1987 4% 25 years
After 15 September 1987 2.5% 40 years

Construction expenditure for tax purposes is the actual cost of constructing the building or rental property. Costs you may include as construction expenditure are:

  • pre-construction expenses including architectural, engineering and excavation fees
  • progress payments to builders, carpenters, bricklayers and subcontractors for the construction of the house
  • payments for the construction of driveways, retaining walls and fences.

Construction expenditure that cannot be claimed:

  • the cost of the purchase of the land that the house is to be built upon
  • the cost of clearing the land prior to construction
  • major earthworks and landscaping.

Cost base adjustments for capital works deductions

When determining a capital gain or capital loss upon the sale or disposal of a rental property, the cost base and reduced cost base of the property must be reduced to the extent to which you have claimed a capital works deduction.

Cost base

You must exclude from the cost base of an asset the amount of capital works deductions you have claimed in relation to the asset if:

  • you acquired the asset after 7.30pm on 13 May 1997
  • you acquired the asset before that time and the expenditure that gave rise to the capital works deductions was incurred after 30 June 1999.
Reduced cost base

The amount of capital works deductions you have or can claim for expenditure you incurred in relation to an asset is excluded from the reduced cost base.

Capital Gains Tax

A typical goal for many investors is to create a larger return or capital gain., but there are certain liabilities that come with capital growth.

Upon selling or disposing of a rental property you acquired after 19 September 1985 you may make a capital gain or capital loss.

You may also make a capital gain or capital loss of some capital improvements made after 19 September 1985 (regardless of when you acquired the property) when you cease to own the property.

You will make a capital gain on the sale of a rental property to the extent that the capital proceeds exceed the cost base of the rental property.

You will make a capital loss on the sale of a rental property to the extent that the property’s reduced cost base exceeds the capital proceeds on the sale of a rental property.

You will make a capital gain or a capital loss pro rata to your interest in the property.

The cost base of the rental property includes the purchase price of the property plus associated acquisition, holding and disposal costs (including legal fees, conveyancing fees, stamp duties and real estate agent fees).

General rule of thumb when understanding capital gains:

  • you’re exempt from capital gains on the sale of your main residence (if you have used the property as your main residence for the whole period you owned it)
  • you may apply the indexation or discount method to determine a reduced capital gain if you have owned the property for longer than 12 months
  • if you used a property as your main residence and then rented it out as a rental property you may only be capital gains exempt pro rata for the time you used the property as your main residence (indexation and discount methods may apply if you owned the property for longer than 12 months).
Methods of calculating your capital gain or loss

There are three methods available to calculate your capital gain or capital loss. While they range from relatively easy to quite complex you should always have your professional overlook any complex calculations with respect to capital gains tax liabilities.

The three methods include:

  • the “other” method,
  • the indexation method,
  • the discount method.
The “other” method

The “other” method is perhaps the easiest of the three methods and applies when you have bought and sold (acquired and disposed) of a CGT asset within a 12 month period.

In this case neither the indexation nor discount methods will apply.

To apply the “other” method, subtract your cost base (the amount you bought the property for) from your capital proceeds (how much you sold it for). The remaining proceeds make up your capital gain.

For example, Candice bought a property for $300,000 under contract dated 20 June 2006, settling on 2 August 2006. Candice paid stamp duty of $7,000 and legal fees of $2,000. Candice sold the property on 20 November 2006 (the date the contract) for $350,000 with expenses of $5,000 in agent fees and $1,500 in legal fees.

As she bought and sold the property within 12 months, Candice must use the “other” method to calculate her capital gain.

Purchase $300,000
Stamp duty $7,000
Purchase legal fees $2,000
Sale legal fees $1,500
Agent fees $5,000
Cost base total $315,000
Candice calculates her capital gains as follows:
Sale proceeds $350,000
less cost base $315,000
Capital gain $34,500
 Indexation method

You can use the indexation method to calculate your capital gain if a CGT event happens to an asset you aquired before 11.45am on 21 September 1999, and you owned the asset for more than 12 months.

When applying the indexation method, you increase each the amount of each element of the cost base by an indexation factor – for example, the consumer price index (CPI).

If the CGT event happened on or after 11.45am on 21 September 1999 you can only index the elements of your cost base up to 30 September 1999:

Indexation factor = CPI for quarter ending 30/09/99 (123.4) / CPI for quarter in which expenditure occurred

If the CGT event happened before 11.45am on 21 September 1999:

Indexation factor = CPI for quarter when CGT event happened / CPI for quarter in which expenditure occurred

The discount method

You can use the discount method to calculate your capital gain if:

  • a CGT event happens to an asset you own
  • it happened after 11.45 am on 21 September 1999
  • you acquired the asset at least 12 months before the CGT event
  • you did not choose to use the indexation method.

The discount percentage is the rate by which you may reduce your capital gain. The discount rate is 50% for individuals and trusts and 331/3% for complying superannuation entities.

Example for using the indexation method versus the discount method:

Craig bought a property for $100,000 under contract on 19 June 1991, settling on 4 August 1991. Craig paid stamp duty of $3,000 and legal fees of $1,000. Cruz sold the property on 15 October 2006 (the date the contract) for $350,000 with expenses of $5,000 in agent fees and $1,500 in legal fees.

As Craig owned the property for greater than 12 months he may apply one of either the indexation or the discount method to calculate his capital gain.

Indexation method calculations:

Purchase x indexation factor $100,000 x (123.4 / 106.0 = 1.164)

$116,400

Purchase stamp duty x indexation factor $3,000 x (123.4 / 106.0 = 1.164)

$3,492

Purchase legal fees x indexation factor $1,000 x (123.4 / 106.0 = 1.164)

$1,164

Sale legal fees x indexation factor $1,500 x (123.4 / 106.0 = 1.164)

$1,746

Agent fees (indexation does not apply)

$5,000

Cost base (total)

$127,802

Craig calculates his capital gain as follows:

Sale proceeds

$350,000

less cost base

$127,802

Capital gain

$222,198

Discount method calculations:

Purchase

$100,000

Stamp duty

$3,000

Purchase legal fees

$1,000

Sale legal fees

$1,500

Agent fees

$5,000

Cost base (total)

$110,500

Craig calculates his capital gains as follows:

Sale proceeds

$350,000

less cost base

$110,500

Capital gain (before applying discount)

$239,500

less CGT discount (50%)

$119,750

Net capital gain

$119,750

Considering the discount method provides Craig with a lessor capital gains tax liability, he will apply the discount method on his tax return rather the amount calculated when applying the indexation method.

Goods and Services Tax, negative gearing and more

In part three of this series we detail more issues for investment property owners, including income tax withholding variations and pay as you go installments.