Depreciation and Property

One of the most under-rated benefits of real estate is the concept of depreciation.

If you own any kind of business, and your net pre-tax profit (after deducting all actual expenses) is, say $100,000, then you can fairly expect to pay tax on that profit. This is like stating the obvious. However, if you own property, and your net pre-tax profit (after deducting all actual expenses) is $100,000, then it is not a forgone conclusion that you will have to pay tax on the $100,000.

The reason for the difference is that with property, you can deduct depreciation. This is a legitimate, legal expense that you can claim, even though it costs you nothing. In other words, you have not spent the money on this expense. To that extent, it is what we call a phantom deduction. In this manner, you may earn $100,000 pre-tax, but only have to pay tax on $40,000.

What makes depreciation even more attractive is that you need not even have paid for the property in the first place. You may be depreciating a million dollar property, but you may have only put up $80,000 in cash. Contrast this with the depreciation on say a car. If you buy a car for $20,000, and you depreciate it, then you can claim a portion of what you paid for it back each year. Even if you bought it on hire-purchase or other terms, you will still eventually have to pay the entire purchase price. With real estate, you may never pay for the property, and yet you can still claim the depreciation on the full transaction value.

Many people use this extra revenue stream from the government (the depreciation write-off) as an excuse to buy negatively-geared property. This is property where the income does not cover the outgoings, and therefore the property is running at a cash-flow loss. These investors relish the idea that the government is subsidising their investment, even though they are losing money. Each to his own, but I would rather make a profit and pay tax, than make a loss and have the government absorb some of that loss. Apart from that, however, it is possible to be positively geared before tax, and yet when depreciation is taken into account, the government considers that you are running at a loss, and therefore gives you more money - with their approval. (By the way, I know of no other business where you can make a profit, but the government considers that you are running at a loss and then subsidises that loss).

Never under-estimate the value of depreciation in property! In fact, one of the wisest investments you can make when you buy a property is to have a valuer go through the property and itemise each and every chattel, fixture and fitting in the property. This includes the curtains, the light fittings, carpets, wall oven, stove, hot water system, air conditioner and more. Whatever the fee charged by the valuer, you will get that back many times over in terms of tax saved or refunded.