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Tax Depreciation: Capital Gains Tax and DepreciationIn order to maximise any tax depreciation claim, the Division 43 Capital Works Allowance and Division 40 Plant & Equipment must be calculated. Division 43 - The Capital Works Allowance is based on the historical construction cost of the building, excluding the cost of all 'plant' and non-eligible items. Any residential building, for which construction commenced after 18 July 1985, is entitled to claim a capital works allowance of 2.5% or 4% for 40 or 25 years respectively from the date of construction completion. All income producing buildings, refurbishments, extensions and fit-outs that have commenced construction within the applicable dates should qualify for this allowance. It is noted that the date the Capital Works Allowance applies for non-residential buildings varies to those mentioned above. Division 40 - Plant and Equipment allows for depreciation on items such as floor coverings, blinds, stoves, lifts, air conditioning, hot water systems and many other items. Many property investors are choosing not to claim the Division 43 Capital Works Allowance that they are entitled to, due to the misunderstanding that if the Capital Works Allowance is not claimed they will not have to reduce the cost base of their property when it is eventually sold. Investors may not realise that under The Income Tax Act the cost base of a rental property acquired after 13 May 1997 must generally be reduced by any Capital Works Allowance that the investor was entitled to claim, even if no claim was made. Therefore, some property investors are missing out on the tax advantages available through the capital works allowance. For example: Adapted from the NTAA Day 1 2005 Tax Schools Seminar Notes. On December 31st 2003 David purchased a rental property for $320,000. He incurred incidental costs (eg legal fees and stamp duty) of $15,000. The building was originally constructed in 1991 and David obtained a tax depreciation report that estimated the construction costs of the building at that time to be $200,000. In his 2004 tax return David claimed the capital works allowance under Division 43, of $2,486, calculated as follows: 2.5% x $200,000 x 182/366 days = $2,486 On January 20th 2005 David sold the property for $400,000. He incurred incidental costs (eg selling costs and agents commission) of $8,000. The property was still tenanted up until this date. For the 2005 income year, David can claim the capital works allowance under Division 43, of $2,781, calculated as follows: 2.5% x $200,000 x 203/365 days = $2,781 As a result, the cost base of the rental property will be calculated as follows: Cost of investment property: $320,000 Add: incidental costs of acquisition: $15,000 Add: incidental costs of disposal $8,000 $343,000 Less: Division 43 deductions (i.e $2,486 + $2,781) -$5,267 Cost Base: $337,733 The capital gain on the sale would be calculated as follows: Sale price: $400,000 Less: cost base $337,733 Capital gain: $62,267 Assuming the capital gain is eligible for the 50% CGT discount, it would be reduced to $31,134. What if David did not make any capital works allowance claim under Division 43? In this circumstance, David would still need to adjust the cost base of his property by the capital works allowance to which he was entitled ie $5,267. Therefore, the cost base would remain at $337,733. It is important for investors who purchased their property after 13 May 1997 to claim the maximum amount of capital works allowance available on their investment property. The cost base of their property will generally need to be reduced by the amount that they are entitled to claim, even if no claim is made. Common CGT Questions:What is a capital gain? With regards to property, a capital gain (or loss) arises upon the disposal of a CGT asset (basically the sale of an investment property). If upon the sale of that property a taxpayer receives capital proceeds in excess of the cost base, the excess will be a capital gain. If I don't claim the capital works allowance will it reduce my cost base when it comes time to sell the property? A property's cost base will ultimately affect the amount of CGT an investor will pay on the sale of an investment property. Any capital works allowance that the investor is eligible to claim will result in a reduced cost base, regardless of whether or not a claim is made. How is CGT calculated at the time of sale?CGT is applied to the investor's profit, which is the selling price minus the cost base (or purchase price) plus incidental costs. Therefore, a reduced cost base will generally result in a higher amount of CGT being paid due to an increased profit. This information is meant as a guide only. Investors should seek professional Capital Gains Tax advice from an accountant. Mortgage House would like to thank BMT Tax Depreciation Pty Ltd for this article. If you are interested in purchasing an investment property, Mortgage House can assist you with the following:
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