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Insights

The depreciation add-back: why claimed capital works reduce your CGT cost base

A property investor sells their long-held rental. The purchase price was $600,000. The sale price is $900,000. The straightforward calculation suggests a $300,000 capital gain. The actual number reported to the ATO is higher — often by tens of thousands of dollars. The reason is a mechanic most investors know exists in outline but few have worked through in detail: the depreciation they claimed against rental income each year reduces the cost base of the property when they sell.

This is the counterintuitive result. Deductions claimed against income are recovered, in part, at the point of sale. The mechanic is not a penalty. It is the operation of the CGT cost base rules.

(This piece is about the depreciation add-back on rental property. This month's companion Accounting and Taxation article looks at another CGT mechanic that catches investors off guard — how crypto-to-crypto swaps trigger CGT events even when no Australian dollars are received.)

The two categories of "depreciation"

Property investors often talk about "depreciation" as a single deduction. The tax treatment distinguishes two categories, and the distinction matters at sale.

Division 43 — capital works. These are deductions for the cost of constructing the building and its structural improvements. The building itself — walls, roof, foundations. Extensions. Driveways. Fixed fittings. For residential properties constructed after 15 September 1987, capital works are deducted at 2.5 per cent per year over forty years (or 4 per cent for certain categories over twenty-five years).

Division 40 — plant and equipment. These are deductions for the decline in value of removable items — dishwashers, hot water systems, air conditioners, carpets, blinds. Each asset has an effective life set by the ATO, and the deduction is calculated using either the prime cost or diminishing value method.

The two categories are usually claimed together, via a depreciation schedule prepared by a quantity surveyor. But at the point of sale, they are treated differently.

The Division 43 mechanic

Division 43 capital works deductions reduce the cost base of the property for CGT purposes. This is a longstanding rule under the CGT cost base provisions of the Income Tax Assessment Act 1997.

The mechanic runs like this. Suppose you purchased a residential rental for $600,000 in 2010. A quantity surveyor identified $200,000 of that as attributable to the construction of the building (as distinct from the land). Over the next fifteen years, you claim 2.5 per cent of that $200,000 each year — $5,000 annually. Total capital works deductions claimed: $75,000.

When you sell the property in 2025 for $900,000, your cost base is not the original $600,000. It is reduced by the $75,000 of Division 43 deductions you have already claimed. Your CGT cost base becomes $525,000. Your capital gain is $375,000 — not $300,000.

The additional $75,000 in the gain is the recovery of the deductions the ATO already gave you over the fifteen years of ownership.

Why this is still, usually, a net positive

Investors sometimes react to this rule as if they were being taxed twice. They are not. They received the benefit of the annual deduction against their assessable income at their marginal rate. At sale, the additional gain is taxed at the CGT rate — which for individuals holding the property more than twelve months is half the marginal rate.

Consider the fifteen-year example above. The $75,000 of deductions were claimed at (say) a 37 per cent marginal rate plus 2 per cent Medicare Levy — 39 per cent. Tax saved during ownership: $29,250.

The same $75,000 comes off the cost base at sale. It is taxed as part of the capital gain. If the seller held the property more than twelve months and is an individual, the 50 per cent CGT discount applies. The taxable component of the recovered $75,000 is $37,500. Taxed at the same 39 per cent marginal rate, the CGT cost is $14,625.

Net benefit: $29,250 saved during ownership minus $14,625 recovered at sale equals $14,625 in the investor's favour. The deduction is not a wash. It is a genuine tax benefit, discounted at sale but not eliminated.

This holds when the investor is an individual with a long holding period. It holds less well when the property is held by a company (no CGT discount) or held for less than twelve months. It reverses if the marginal rate at sale is significantly higher than the rate during ownership.

Division 40 is different

Plant and equipment deductions (Division 40) are treated through a different mechanism called a balancing adjustment. When the property is sold, the depreciable assets are effectively disposed of at their market value at sale. If the amount attributable to the plant exceeds its depreciated value, the difference is included as ordinary income. If less, it is deductible.

Division 40 deductions do not affect the CGT cost base of the land and buildings. They are dealt with separately, at the point of disposal.

One additional point: since 9 May 2017, second-hand plant and equipment in residential rental properties can no longer be claimed for depreciation. Only new assets purchased by the current owner qualify. This has narrowed the Division 40 impact for many residential investors who acquired properties after that date.

Practical points

Records matter. Depreciation schedules prepared during the ownership period are the primary evidence of claimed capital works. They should be retained until at least five years after the property is sold, alongside settlement statements and any construction cost documentation.

Never claimed but eligible? If you were eligible to claim capital works deductions but did not — often because you didn't have a quantity surveyor's report and the original construction cost was unknown — the ATO's practical guidance (PS LA 2006/1) provides that the cost base need not be reduced by amounts you could have claimed but did not. This is a narrow exception and depends on the facts.

Selling in the near term. If a sale is contemplated within the next few years, the value of a fresh depreciation claim can be weighed against the near-term cost base recovery. In some cases — short expected holding period, minimal remaining schedule — the trade-off narrows to the point where the annual deduction is worth reviewing rather than assuming.

The principle

The depreciation add-back is not a trap. It is the operation of the CGT cost base rules interacting with the annual deduction rules. Both are longstanding. Both are documented. Both are known to any adviser who works in this area regularly.

The disciplined investor understands the mechanic before the sale, not after. The seller who is surprised at settlement by a capital gain larger than the price change suggests is usually the seller who claimed depreciation without understanding what would happen at disposal.

Cost and tax are the certainties of investment. The mechanics are worth knowing before the transaction.

If you would like to review the CGT position on a rental property you are considering selling — or the depreciation schedule you have been claiming against — we welcome the conversation.

Corinne Kirk
Partner, Accountant

1300 102 542 | 0405 106 401
corinne@egu.au

Sources

This is general advice. It does not take account of your objectives, financial situation, or needs, and is not a substitute for advice that does. Before acting on anything in it, consider whether it suits your circumstances, and consider the relevant Product Disclosure Statement.

Corinne Kirk