With the opposition outlining its platform for changes to negative gearing and the government refusing to rule them out, will this be an end to tax depreciation on investment properties?
With debate in full flow around the implications of proposed changes to negative gearing and capital gains exemptions, there is need for further consideration for property investors and their ability to offset the “non-cash” loss of income generating assets via depreciation.
“Depreciation of capital and plant and equipment associated with an investment property is very much wedded to the benefits of negatively gearing a property, which allows an owner to offset 'non-cash' losses against other taxable income," said tax and assets services manager Zac Gleeson. "This reduces an individual’s personal tax liability over the shorter term, whilst reducing the cost base and allowing the government to gain a greater take of tax on the sale of the asset over the longer term. This delayed approach had the impact of encouraging investment in low yielding asset classes.”
Is it worth claiming depreciation on an investment property if you cannot offset the loss?
Any proposed changes by either the government or the opposition which impact negative gearing could have a flow on affect to the overall benefit of depreciation.
Gleeson is continually being asked by investors “why would I want to claim depreciation on properties that are negatively geared in the current year when it won’t reduce my income, but will have the impact of reducing my cost base when I sell?”
This view is that investors will only want to claim depreciation on properties that are cash flow positive to a point where they are breaking even.
“Claiming depreciation is an incentive that is available, but isn’t a choice – if you don’t claim it in full you may miss out," said Sian Sinclair, tax partner at Grant Thornton. "The adjustment to the cost base of an asset has to be made regardless of whether you have chosen to claim depreciation in the past or not, so why miss out on claiming the entire deductions that are, at least partially, going to reduce your cost base anyway."
Gleeson noted that there are two further points that must be taken into account under Labor's proposal.
“Firstly, it suggests that any losses incurred can be carried forward to offset against any future gains on sale, therefore reducing the potential CGT," he said. "Secondly, investors who purchase an Investment property post 1st July 2017 lose negative gearing tax offsets, and face a double whammy with a reduction in the 50 per cent CGT exemption to just 25 per cent.”
The current government is remaining coy about negative gearing, though they have ruled out changes to CGT exemptions (at least outside of superannuation). It appears that their preference is for a cap on deductions, perhaps up to a percentage of their income.
Taking the assumptions made as part of Labor’s proposed reforms currently under scrutiny, Gleeson has provided a worked example of a new negatively geared property purchased for the median BCC house sale price (as at January 2016), of $610,000 to demonstrate the impact. This example assumes the property was neutrally geared prior to depreciation being applied and remained so for the five-year holding period.
If we assume a five-year holding period on the investment, the current capital allowance depreciation deductions under Div 43 is $27,500. Under the new proposals, there would be no direct benefit from claiming depreciation year on year as there is no direct effect on the property investor’s cash flow and no ability to offset any “losses” against personal income.
Under the current rules, when the investment runs its course over the five years, the net effect of the cumulative depreciation offset is likely to be as high as $15,939 based on a marginal tax rate of 37 per cent.
The real loss directly impacts the net tax position of the property investment when the property investor sells the asset, as it results in a typical investor paying approximately 84 per cent more in tax on their investment property over a five-year holding period.
“When directly considering the effects of the proposed changes on depreciation relating to negatively geared existing properties purchased post 1 July 2017, the effect could be dramatic," Gleeson said.
"Depending on how deducting the cumulative losses on the property is handled within the CGT calculation, depreciation will still need to be known at the CGT event to reduce the capital gain. However, the difference depreciation makes on CGT is diminished by the decrease in the exemption. Additionally, the cumulative losses are deducted from the capital gain but the investor has received no tax benefit from those losses throughout the holding period, which also reduces the positive effect depreciation has on an investor’s cash flow.”
Is depreciation here to stay?
The incentive to produce income-generating assets rather than focusing on the tax liability incentives is likely to change an investor’s portfolio mix, which is also likely to have an impact on demand for certain types of property. This may also change the dynamics of financing these investments if the incentive to negatively gear a property is removed. Over time, it may give rise to a greater need for depreciation as a result of cash flow positive properties needing to offset non-cash losses against the profits generated on a positively geared property.
So the question remains, who wins under these proposals? Is it purely an opportunity to raise revenue for the government as an alternative to a change in the GST or a safer bet than taking on superannuation? Are there bigger winners and losers falling out of the longer term impacts to the property and finance sectors?
The good news is that depreciation is here to stay. It is a legitimate claim on the fair wear and tear on a building and the fittings within. Labor's proposal may diminish the positive effects depreciation has on a negatively geared existing property but it doesn't negate the need to claim depreciation. Positively geared properties as well as new properties will continue to benefit as before.