There’s no such thing as a free lunch. An oldie but a goodie – especially when it comes to tax deductions. Often you hear people justify buying a product or service because it’s a ‘tax write-off’ – and while that may be true, it still comes at an expense. So while the purchase might reduce your taxable income, the funds to purchase still have to come from somewhere. And that somewhere is your (or your company’s) pocket.
Today we’re discussing this in relation to property – specifically, property depreciation.
Depreciation is a reduction of the value of an asset over time, especially due to wear and tear. Here, we are talking about the value of a property itself – the ‘bricks and mortar’, not the land.
Here is an example. You buy a property for $400,000, but $200,000 of that is the value of the land. So the structure itself (the building) is worth $200,000. Each year, when it comes to paying your taxes, you are able to claim up to 2.5% of that value in depreciation costs. What that means is that essentially, the house that you bought for $200,000 would be worth nothing after 40 years’ time in relation to that 2.5% rate of depreciation per annum.
Obviously, in those 40 years, you would most likely replace, rebuild or renovate a lot of things before that happened.
Usually, land value goes up. If there are 2 properties side by side with the same land value and the same dimensions, but one house is brand new and the other is 40 years old, the new house would be worth a lot more due to the value of the building itself.
What does this all mean for potential property investors? It means that the value of the building should be carefully considered before signing the paperwork. An old house means a lot of repairs. Repairs, maintenance and renovation costs are often high – and often overlooked. If you buy a house that is completely dilapidated, you are essentially just paying for the value of the land.
Let’s take a look at another example.
Total property value: $700,000
Value of land: $300,000
Value of the house: $400,000
For this property, you could claim $10,000 a year in depreciation. Therefore, if you were getting $25,000 in rent for the property, you would only get taxed on $15,000 after the tax deduction.
Of course, there are many other costs associated with owning a home. In Podcast 94 we discussed this in detail, so have a listen to that for more information. As a rough guide, home owners are looking at around $7,500 - $8,500 a year just in property maintenance costs, for things like electrical and plumbing repairs, roofing, painting, air-conditioning and so on. There are things like termite damage (just ask Michael!) which is fairly common in North Queensland, and there may be other expenses dependent on different geographical locations. It won’t necessarily be that exact amount each year, as some costs only occur every 15-20 years, but that’s the rough average per annum.
If you buy the $700,000 property mentioned above (with the building valued at $400,000), keep it for 19 years without making any changes to it and then sell it for $700,000, it appears you have made no capital gain – but actually you’ve made $190,000 because that property has depreciated at a rate of 2.5% per year for those 19 years ($10,000 a year).
In the above example, you may not actually spend the $10,000 on the house in that same financial year. If you buy an old house and it costs you $50,000 to renovate the kitchen and flooring, you can still only claim the 2.5% depreciation in that year. So while it is a deduction, it’s also an expense. There’s no such thing as a free lunch: tax deductions are good, but sometimes people don’t see that it actually comes at a cost to them. To get the deduction, they have to spend the money.
When you consider any investment, always look at the true after-tax and after-expense gains.
Dallas Davison, Michael Hogue and Ali Hogue.