Depreciation can be a useful property investment tool: Mark Armstrong

I was driving in my car the other day when I heard a radio ad from a group that sells brand new property. The ad said the group only recommended properties in areas that have shown growth that is double that of Melbourne’s growth rate.

The statement got me thinking that just because you buy in a suburb that has had strong growth, it does not mean all property in that area will be a solid investment.   

Take a look at the properties below.

These apartment blocks are located in the blue-chip suburb of Prahran. They each have a similar number of units and sit on similarly sized blocks of land. The only difference is that one was built in the 1960s and the other in 2000.   

Two-bedroom apartments in the 1960s block were selling for less than $200,000 in the year 2000. Conversely, the similarly sized apartments in the new block were fetching over $400,000. Investors who purchased one of the new apartments were paying a premium because they were new.

Today, the older apartments are worth about $550,000 and have been growing by about 10% each year relative to their purchase price. Conversely, the new ones have been growing by closer to 5% per annum and are worth approximately $600,000.   

So why has one grown by $350,000 and the other by $200,000 over the same time frame?  

It is because when you buy something brand new, it begins to depreciate - or lose value - the minute it is used.

A new car, for example, starts to depreciate as soon as you drive it out of the dealership.

Residential property is no different. The building itself, along with fittings and fixtures like floor coverings, stoves and hot water systems (to name but a few) loses value over time.

By contrast, the land underneath the building appreciates or increases in value. This is because buildings, fittings and fixtures are replaceable, while land is not.

The ATO recognises that depreciation is part of the cost of holding an investment property, along with expenses like municipal rates, insurance and interest on the loan. Hence, it allows you to claim depreciation as a tax deduction.

In the case of a building, depreciation is claimed over 40 years. For most fittings and fixtures, it’s claimed over five to ten years.

Depreciation can only be claimed for investment properties, not the family home. Claiming depreciation each year can help make it more affordable to hold onto your investment property, because it reduces your taxable income and therefore your tax bill. Basically, it’s a tool to help manage your cashflow.   

Whilst depreciation is often touted solely in terms of its benefits, much less is written about the potential downside.

For starters, depreciation is really just a fancy way of saying that your property is losing value. Even if you don’t claim depreciation as a tax deduction, the property is still losing value. And, because the objective of holding a residential investment property is to achieve long-term capital growth, a property that’s losing value can’t be considered a good investment.

Second, if you do choose to claim depreciation as a tax deduction it will increase the amount of capital gains tax when sold. The ATO allows you to depreciate the building by 2.5% per annum but this will reduce the cost base of the property for tax purposes.

For example, if you buy a property for $500,000, including costs, and claim $25,000 in building depreciation, the tax department will recalculate the cost base to $475,000. If you sell the property for $600,000 your capital gain will be $125,000 not $100,000 as many people believe.

Third, most depreciation occurs within the first five to 10 years after you purchase a brand new asset. If you buy a house or apartment when it’s brand new, or in the first few years afterwards, the building will be losing value.

There is a danger that the depreciation of the building may be greater than the appreciation of the land it sits on. This could result in a loss when you sell.  

Fortunately, there is a way you can minimise the downside of depreciation, yet still gain some of its benefits.

By selecting an investment property that is at least 10 years old, and holding it for a minimum of seven to 10 years (the length of a full property market cycle) you’ll still be able to claim some depreciation, whilst giving capital growth a chance to counteract its effects.  

When used wisely, depreciation can be a useful tool in managing cashflow and helping you hold the investment over the short term. But if you focus equally on the long-term outlook by choosing an asset with strong capital growth potential, you can maximise the value of your property and take much of the sting out of the depreciation tail.

Mark Armstrong is a director of iProperty Plan, which provides independent analysis and tailored advice to investors and homebuyers.