Wealth Power of Property

In 1969 we published a book called "How To Get Real Estate Rich". One chapter dealt with depreciation or should we say the lack of it. The United States has for many years allowed property investors to depreciate real estate improvements, that is, to allow the cost of buildings to be depreciated annually as an expense against income. The Americans went even further by allowing that depreciation to be accelerated down to, in certain circumstances, a four year period.

The plain fact is that buildings do lose value with age. The cost of replacement will in most cases exceed the value of older property. That stands to reason. Why should it not be a charge against income. It does actually create an expense.

The land on which the building sits invariably increases in value. Mostly, only the land increases in value, as buildings decline in value to less than replacement cost and ultimately to zero. A temporary exception can be seen in periods of high inflation which pushes up the value of second hand property as it is dragged along by the higher cost of new construction.

Although this represents added value it does not represent a real gain after allowing for the inflationary factor. In simple terms it costs more to replace the same product than it can be sold for on the open market. The improvements suffer a loss in value even if the land has appreciated.

At the time we published "How To Get Real Estate Rich" we took the matter of depreciation on property to the then Minister of Finance in the sitting coalition conservative party. We received a good hearing and acknowledgment that the idea of allowing depreciation deductions for tax purposes on property had not been considered previously, that it had merit and would be put to the government of the day.

At the same time many on the opposition benches and their supporters were screaming for a capital gains tax. The supporters of a capital gains tax had failed to appreciate the justifiable and fair argument that it was not reasonable to tax gain if at the same time depreciation on improvements was not recognised as a tax allowance.

If not, it virtually meant that capital gains tax would be applied to improvements that were really experiencing a capital loss. Ultimately it was the Hawke Labor Government with Paul Keating as Treasurer that in September 1985 introduced a capital gains tax.

Although capital gains tax applies to gains on any commodity, with some exceptions for personal property and now small businesses, we will confine our attention here to property. When capital gains tax became tax law a number of concessions came with it. The family home or principal place of residence was exempt from assessment under the legislation. Although expected, it was a major advantage for property owners.

With capital gains tax the Government recognised the inequity of the tax unless it was accompanied by a depreciation allowance and introduced an allowable figure of 4% of the cost of improvements. In a further display of fairness the capital gains tax and depreciation allowance would only apply to property purchased, or construction commencement in respect of depreciation allowance, after the day of announcement. But there was a poison pill. Until that date all interest on borrowed funds used to make the purchase were fully and totally deductible against income.

The new provisions were to quarantine interest deduction to a break even figure. Interest charges when added to other outgoings such as rates, insurance, body corporate fees, management charges etc were only allowed to be deducted as an expense up to the figure that represented a break even return. This effectively eliminated negative gearing which was the intention.

Up until then losses over and above break even could be offset against other assessable income providing a favourable tax advantage. The idea was to shut down the use of negative gearing as it was seen as an unfair advantage to higher income earners. It backfired. Those who had entered into the residential property market and taken advantage of negative gearing lost enthusiasm for the venture and those who had not up until then entered the market had much less inducement to do so.

Who then was going to provide the residential accommodation for the 30% of the population who choose or need to rent and not buy. A desperate shortage of rental property developed. Residential rents went through the ceiling. Many investors sold out of the residential market and scared off other potential residential investors who looked in other directions. Long queues of tenants formed outside real estate agents’ offices before they opened for business and on the spot auctions were held with the lease being signed with the highest rent bidder.

The legislation was hurting those it had sought to help, increasing rents to levels that were out of reach for average families. The rate of new construction slowed exacerbating the situation. The Government could also see that more public housing would be required at high cost to taxpayers.

By September 1987 the Government realised its mistake and amended the law. The quaranting of losses was repealed and as an offset the allowable depreciation figure of 4% per annum on the cost of improvements was reduced to 2.5% per annum.

Thankfully and rightfully all interest expenses and other costs were once again fully deductible. Of particular note is the fact that the 4% per annum allowance remains in place for that hiatus period July 1985 to September 1987. This provides a real window of opportunity for property where construction commenced during that period. Many properties fit that requirement and if sought and found can provide excellent tax free income to the limit of the allowance. So do not overlook the benefits of those properties. It is a real find and one not many investors seeking property realise.

To return interest and expenses to fully deductible status was a relief to the market and giving up the difference between 4% per annum depreciation and 2.5% per annum was not a big price to pay. Before we explore the great advantage of depreciation, it needs to be expressed here that with the introduction of capital gains tax, property purchased after September 1985, but built prior to July 1985 would incur capital gains tax when sold but would not qualify for deprecation at either 4% or 2.5%. Those properties suffer the worst of both provisions and should be avoided unless they have some other economic advantage such as a bargain purchase price or exclusive location or the like. Although we have been keeping our eye out for such a deal since 1985 we have not found one yet. The advantages to the investor of newer property are so good that to find a comparable investment built pre 1985 is unlikely.

Most people considering the residential market we find, do not fully understand the impact of this tax break. 2.5% per annum does not sound like a large amount but 2.5% of the cost of construction can amount to up to one third or more of the income of the property being tax free. Not many investments can boast that advantage. If 4% per annum depreciation applies that tax free income can be even more.

Where we discuss the accumulation of assets in other chapters we more fully expand on the use and benefits of building depreciation. For now, and for those who have not had first hand experience, we should look at the basic principle so it can be fully understood and seen for its exceptional benefits.

A purchaser buys a home unit at a cost of $200,000 and the cost of construction is established at $100,000. Being newly constructed, it qualifies for 2.5% per annum depreciation. The rental value is determined at $250.00 per week.

The depreciable construction cost was established at $100,000 so the annual depreciation allowance is 2.5% of that sum or $2,500 per annum.

That $25,000 is a non cash outgoing. It does not come out of your pocket nor is it an actual cost out of income, it is purely a tax concession.

The depreciation allowance of $2,500 per annum in this example causes just under 20% of the gross rental income to be tax free. This allowance continues each and every year for the next forty years. A total tax deduction of $100,000, not a bad concession.

Another tax benefit for property investment is depreciation allowance on fittings, fixtures and furniture including the cost of carpets, blinds, light fitting, curtains, hot water systems, ovens, ranges and many more. A full schedule is provided at the end of this chapter. It has always been that these items can be depreciated over their economic life. We again refer to fixtures and fittings depreciation in the chapter "Establishing A Net Yield".

These rates can be increased under accelerated provisions to increase the annual tax benefit and should be discussed with the accountant preparing your annual tax returns.

GENERAL	PRIME COST	DIMINISHING VALUE
Air-Conditioning Plant - Central (ducting & vents) - Installed Additions - Room Units - Solar Energy Powered	13 7 17 13	20 10 25 20
Alarms	13	20
Antenna System	12	18
Art Works	1	1.8
BBQ’s	20	30
Billiard Tables	7	10
Blinds	13	20
Caravans - General - Used Only With Car	20 17	30 25
Carpets - Business Places, Hotels - Rental Properties - Picture Theatres - Professional Chambers - Ten Pin Bowling Centres	27 17 27 17 40	40 25 40 25 60
Chain Saw	40	60
Clothes Dryer	20	30
Curtains & Drapes	20	30
Dishwasher	18	27
Drays & Wagons ( Farms & Stations)	17	25
Dredges	13	20
Electric Bed	13	20
Electric Clock	13	20
Electric Heater	17	25
Electricity Mains	10	-
Electronic Heating Units	17	25
Espresso Coffee Making Machine	13	20
Fences - Electric - Wire Mesh	13 13	20 20
Fire Hose Reels/Extinguisher	13	20
Fire Sprinkler System	13	20
Fire Water Service	7	10
Fittings & Fixtures in Cafeteria, Rest, Recreation & Locker Rooms	33	50
Floor Installations "Free Access" Floors in Computer Rooms	7	10
Fluorescent Lighting Units	13	20
Furniture	13	20
Galvanised Iron Tanks - Bore water - Rainwater	13 13	25 20
Garbage Bins	20	30
Garbage Disposal Units	20	30
Garden Watering Systems	6	9
Gas & Water Fittings	13	20
Gas Coppers	13	20
Gas Cylinders LPG	13	20
Gas Mains	7	10
Glass Houses - Timber Framed - Metal Framed	13 7	20 10
Gymnasium Equipment	17	25
Hot Water Systems	13	20
Intercom System	20	30
Kindergarten Furniture & Play Equipment	27	40
Lamps - Arc	17	25
Laundry Plant - General - Washing Machine	17 20	25 30
Lawn Mower - Motor - Self Propelled	20 27	30 40
Letter Boxes - Private, Polycarbonate - Aluminium, Nylon, Brass	13 7	20 10
Lifts & Elevators - Electric - Hydraulic	13 13	20 20
Linoleum Floor Coverings	17	25
Main Switchboard	13	20
Mechanical Ventilation	13	20
Microwave Ovens	20	30
Mobile Sheds	17	25
Motor to Garage Door	13	20
Natural Gas Pipeline	13	20
Neon Signs	13	20
Partitions - Demountable	13	20
Pianos	13	20
Plant - Live Indoor - Simulated	27 13	40 20
Pool Furniture	13	20
Portable Toilet	17	25
Pumps	13	20
Radios	17	25
Refrigerators	13	20
Safe - Portable	7	10
Sauna	13	20
Security Gate	13	20
Spa (Fibreglass)	13	20
Stoves	13	20
Supa Grass - Synthetic Tennis Court Surface	17	25
Swimming Pools - Above Ground - Concrete - Fibreglass - Filtration Equipment - Other Equipment	17 7 13 13 13	25 10 20 20 20
Tarpaulins (Canvass or Plastic)	20	30
Television Set	17	25
Tennis Court Equipment - Of Bitumen Composition - Flexipave Surfacing - Synthetic Lawn Surfacing	13 13 17	20 20 25
Trampolines	17	25
Vacuum Cleaners	17	25
Vinyl Floor Coverings	17	25
Water Mains	7	10
Wells	7	10