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How does depreciation work?

Depreciation can be one of the most significant drivers of cash flow for a property. 

Depreciation for properties takes two forms:
•Plant and equipment or fittings - ovens, air conditioning, carpet or furniture if you furnish your rental property.
•Capital works deductions - Construction expenditure

It is deemed by the tax office that the useful life of the above assets decline over time through wear and tear. To be compensated for that decline in value, each year the investor is allowed to claim a tax deduction equivalent to that decline and therefore reduce the net income for the property. 

The beauty of depreciation is that it is a non-cash item. Unlike other expenses like loan interest you do not physically pay any cash to meet the expense. It is a paper deduction only. For this reason many investors seek out property that has a high level of depreciation, so they can reduce their taxable income without any cash outlay. Boosting their tax refund and hence the cashflow connected to the property. 

The highest level of depreciation is typically found in newly built properties which have not been previously occupied. Because they have not been occupied they will have no wear and tear and therefore have maximum deductibility. Whereas older properties will tend to have little to no depreciation available as the useful life of the building and fittings has already been expended. 

An important note about Capital works deductions

Capital works can be claimed at 2.5% of the construction value over 40 years from the date of construction. For example if the construction for a new property was $200,000 then the investor can write down their income by $5000 a year for the next 40 years if they continue to hold the property.

Note however if an investor bought a property that was 20 years old, then they would only be able to claim a capital works deduction for the next 20 years as the first 20 years of useful life have already passed. 

Further to this the value of the capital works is determined by cost of construction at the construction date. Twenty years ago the build cost would have been approximately $50,000. Therefore the investor will only be able to deduct $1,250 per annum (2.5% of $50,000) over the next 20 years. Therefore the investor is missing out on $175,000 in potential tax deductions.

If the property was built pre 17 July 1985 then different rules apply.