Hey everyone and welcome back. Today we’re going to be tackling a topic that we get asked about a lot by you, our awesome listeners, and that’s depreciation. Specifically, how it plays into capital gains tax when you decide to sell that investment property.
Yeah, it’s one of those things that can seem a bit confusing at first glance, for sure.
But understanding the ins and outs can really make a difference.
Definitely. Being a savvy property investor means getting a handle on depreciation, wouldn’t you say?
Absolutely. So, let’s say I’ve just bought this amazing investment property. Congrats to me, right? What exactly can I depreciate? Is it like writing off a chunk of the entire property each year?
It’s a great question and you’re not alone in wondering about that. The thing is with property depreciation, you’re not depreciating the land itself, right? Because land generally holds its value pretty well.
Exactly. Instead, we’re zeroing in on two main areas. The actual building and all the goodies inside that make it liveable.
Okay. I’m intrigued. Break it down for me. What are those two areas?
All right. So, picture this. You’ve got the building structure.
Yeah.
The walls, roof, those permanent fixtures.
Got it.
That falls under what we call capital works allowance.
Capital works allowance.
Right. Then there’s all the stuff you can easily remove or replace. Things like carpets, ovens, that fancy dishwasher you splurged on.
Makes sense.
Even air conditioning units. All those goodies fall under what we call plant and equipment depreciation.
Plant and equipment.
Basically, you’re acknowledging that these have a lifespan,
right? They’ll eventually need replacing or at least a serious upgrade.
Exactly.
So, it’s like getting a little tax break each year to help cover those eventual costs down the line.
You got it. It’s a smart way to offset your taxable income while you own the property.
Okay.
But here’s where it gets really interesting, and this is where it all ties into capital gains tax when you decide to sell.
All right, let’s unpack that a bit. How does claiming depreciation actually affect my CGT liability down the road?
So, every time you claim that depreciation deduction. You’re essentially reducing what’s called the cost base of your property.
Cost base. Okay. Now, that rings a bell. That’s a key ingredient in figuring out my capital gain when I sell. Right.
You got it.
Right.
The ATO looks at your sale price minus your cost base, and that’s how they determine your taxable gain.
Right.
And guess what gets factored back in when you sell?
That’s all those depreciation deductions you’ve been diligently claiming.
Wait, so I’m basically paying back those deductions through my CGT. That doesn’t sound like a great deal.
No, hold on. It’s not as bad as it sounds. Yeah.
Remember that sweet CGT discount you get for holding an asset for longer than 12 months.
Oh yeah, right.
In Australia, that’s a 50% discount on your capital gains tax.
Okay. So, it’s not a dollar for-dollar payback. The CGT discount softens the blow a bit.
Yes, but wouldn’t it still be better to, I don’t know, just not claim depreciation and just keep my cost base high? See, that’s where things get really strategic. Simply focusing on those immediate numbers can be a little misleading. Let’s paint a picture, okay? Imagine you snag that property for $500,000 and then a few years later, boom, you sell it for a cool $750,000.
Okay, nice work. By the way, your capital gain is $250,000. Right.
Right.
But with the CGT discount, you’re only taxed on half of that.
So, I’m only paying tax on $125,000 of my gain. You know, that is a game changer. But those depreciation deductions, they’re still lurking in the shadows, aren’t they? They are. You’re right. But here’s another thing to consider. Your marginal tax rate.
Okay, remember capital gains tax, it gets added to your income for the year, right?
If you’re in a higher tax bracket, let’s say you’re paying 45% on some of your income, the impact of those recapture deductions, it’s actually lessened.
Interesting. So, the higher my tax bracket, the less those deductions sting when I eventually sell. It’s almost like they were more valuable to me when I claimed them initially. Precisely. You’re getting the most bang for your buck when you need it most. those early years of ownership. But, and this is a big butt, we haven’t even touched on the most compelling reason why claiming depreciation is a no-brainer.
All right, you’ve got me on the edge of my seat here. What’s this mystery reason?
It’s the power of the time value of money.
Okay, time value of money. I’ve heard that phrase before, but honestly, it always sounded like a bit of financial jargon to me. Can you break it down?
Sure. Think of it this way. Money is like, say a freshly baked cookie.
Okay. It’s always more tempting right now in the present than it is in the future,
right?
That’s because of inflation. A dollar today, it’s worth more than a dollar will be in 5, 10, 15 years.
Okay, that makes sense.
So, when it comes to depreciation, you’re essentially getting those tax benefits back in your pocket right now when you can actually enjoy that warm gooey cookie.
So, I can use those savings to, I don’t know, reinvest, maybe pay down debt faster, or even just cover those everyday expenses that life throws my way.
Now, you’re getting it. It’s all about leveraging the power of compound growth over the long term.
That makes perfect sense. By claiming depreciation, I’m not losing out on money. I’m just shifting its value to a time when it benefits me most.
Now, you’re thinking like a strategic investor.
It’s about looking at the bigger picture, understanding how these financial levers work together.
So, we’ve covered the CGT discount. We’ve talked about the impact of my tax bracket and that power of the time value of money. All really compelling reasons to claim name those depreciation deductions. Is there anything else we need to consider when it comes to this dynamic duo depreciation and CGT?
Well, one crucial aspect is how depreciation can actually kind of, I don’t know, supercharge your investment journey.
Okay.
Particularly in those, you know, those critical early years.
You mean that period when I’m laser focused on building equity and honestly just making sure my investment is actually sustainable.
Yes, exactly. In those early years, maximising your cash flow, it’s absolutely crucial. You’ve got your mortgage repayments, you know, council rates, maybe even property management fees if you’re not managing it yourself. Sure,
depreciation deductions. They can be a game changer for your cash flow during that make or break period.
It’s like having a secret weapon to combat those holding costs and just give my investment that fighting chance to thrive.
Precisely. It can be the difference between feeling financially stretched by your investment property and comfortably covering those costs while your property, you know, steadily appreciates in value.
This has been incredibly eye opening. It’s not just about understanding, I don’t know, the mechanics of depreciation and CGT, but it’s about recognising their strategic role in my overall investment journey. But before we get too far ahead of ourselves here, is there anything else we need to know about how these two interact? This has been incredibly eye opening. It’s not just about understanding, I don’t know, the mechanics of depreciation and CGT, but it’s about recognizing their strategic role in my overall investment journey. But before we get too far ahead of ourselves here, is there anything else we need to know about how these two interact?
You know, it’s interesting. While we’ve been unpacking all those financial nuts and bolts, property investment is as much about your mindset, I think, as it is about the numbers.
That’s an interesting perspective. What do you mean by that?
Well, it’s easy to get caught up in the what ifs and the potential downsides, like, oh no, a slightly higher CGT bill years down the track. But here’s a powerful reframe for you: worrying about capital gains tax means you’ve actually made a profit on your investment.
That’s a brilliant way to look at it. A good problem to have, as they say.
Exactly. And remember, CGT is only something you deal with when you sell, you know, years down the line. Depreciation, on the other hand, it’s your trusty sidekick, you know, throughout your investment journey, helping you manage that cash flow and potentially reach those financial goals faster.
So, it’s about focusing on the tangible benefits I can access today while keeping an eye on the future. Sounds like the relationship between depreciation and CGT. It’s all about strategic timing.
Absolutely. Think of it as a dance, not a duel. You’re not trying to avoid CGT altogether. You’re learning how to factor it into your overall strategy and maximizing your gains along the way.
This has been an incredible deep dive. We’ve demystified depreciation. We’ve tackled the CGT puzzle. Even learned how to leverage the time value of money. What are your final words of wisdom for our listeners out there who are keen to, you know, really make those smart investment decisions.
Don’t be afraid to claim those depreciation deductions. They’re a really powerful tool. They can make a real difference to your investment journey. Just remember to factor them into your long-term financial planning. Our friends from MCG Quantity Surveyors specialise in creating tax depreciation schedules can help to ensure you’re maximising your deductions while being mindful of how it might affect you later. And of course, it is always a good idea to consult with a qualified tax advisor to tailor a strategy that aligns with your own, you know, unique circumstances.
Fantastic advice. And on that note, we’ll leave you with this thought-provoking question. How can a deep understanding of depreciation and its relationship to capital gains tax empower you to make, I don’t know, bolder, more informed investment decisions.
The world of property investing is full of opportunities. Arm yourself with knowledge and go make it happen.
That’s a wrap on today’s deep dive. We hope this episode has left you feeling informed, inspired, and ready to take your property investing game to the next level. Until next time, happy investing.
