The real impact of changes to depreciation

It’s been a couple of weeks since Treasurer Scott Morrison delivered the 2017 Federal Budget, and since then we have had numerous conversations with clients about the depreciation changes announced in the budget.

Many people are worried they will no longer be able to claim depreciation on their existing properties. This is not the case at all. In fact, the changes that have been announced will only impact a portion of depreciation claims on property assets, and they will have no impact on existing investments.

Let’s break it down:

What are the changes?

As reported in the Budget Statement, “From 1 July 2017, the Government will limit plant and equipment depreciation deductions to outlays actually incurred by investors in residential real estate properties. Plant and equipment items are usually mechanical fixtures or those that can be ‘easily’ removed from a property such as dishwashers and ceiling fans.”

The government’s intention behind these changes to the way depreciation is claimed on property is to help “reduce pressure on housing affordability”. It is projected that it will save them several hundred million dollars over the next few years.

More changes for property investors in the 2017 Federal Budget

What is Depreciation and how does it work?

Which properties are exempt?

- Commercial and Industrial Properties

Commercial and industrial properties are not affected by this policy change, as it relates to residential properties only.

- New properties

You will still be entitled to all the depreciation benefits if you decide to purchase a brand new investment property. (Check out some other advantages when investing in new properties.)

- Existing properties purchased prior to May 9th 2017

Existing residential investment properties that were purchased (contract exchange date) prior to 7.30pm on Tuesday May 9 2017 are also not affected.

The changes are grandfathered, which means any properties that are already in your portfolio will be exempt from this policy. You can continue to claim full plant and equipment deductions on these existing investments until you no longer own the asset, or until the asset reaches the end of its effective life.

For example: if you currently own a 10-year-old apartment in a high-rise building that attracts $5,000 in plant and equipment benefits this year and $4,000 next year, you will continue to be allowed to claim this full tax deduction. It’s only those who are buying an investment property post-May 9 who are affected by these changes.

How will future property investments be impacted?

When purchasing existing properties, under the new depreciation rules, only capital works can be claimed on your tax return. In other words, plant and equipment deductions from the previous owner are now not claimable. The best way to explain the financial impact of these changes is through a hypothetical case study.

Let’s go back to our previous example of a 10-year-old apartment in a high-rise building. A quantity surveyor has prepared a report and determined that the construction costs of the property, an allowable tax deduction under capital works, amounts to $7,000 per year over 40 years.

Now, before May 9, the deduction may have looked something like this:

Capital works deduction: $7,000

Plant & Equipment deduction: $6,000

Total depreciation deduction: $13,000

If you were to purchase this property today (after May 9, 2017), you would be missing out on an annual tax deduction worth $6,000.

Assuming you were a top income earner paying 47% tax (0.45c in the dollar plus 2% Medicare levy), this would cost $2,820 per year, or around $55 a week.

Yes, it’s a loss, but it’s not enough to make the prospect of investing wholly unappealing, nor does it make investing in property completely unaffordable.

It’s also important to note that plant and equipment claims are usually highest in the first few years of owning a property, particularly year one. This is because P&E depreciation is based on the effective life of the equipment, which diminishes substantially each year. By year five, P&E deductions generally only amount to $1-2000 per year. Therefore, if you buy an existing property that is over 10, 15 years old, then the impact is minimal. And if you acquire a plant and equipment item after you acquire the property, such a washing machine, new light fittings, etc… you can depreciate this item.

As we know, investing in property is a long-term enterprise so when we adopt a broader view, we can see that these changes, while frustrating, won’t change the game for property investors quite as badly as first thought.

In summary:

  • All changes are grandfathered, investors who purchased their investment properties before May 9, 2017 need not panic.
  • When purchasing existing investment properties, depreciation benefits are still available; they have just been reduced.
  • Brand new properties will not be affected by the new policy, and will offer the greatest depreciation benefits going forward.