Residential rental property and depreciation
Depreciation is the reduction in value of an asset over time due to wear and tear. In New Zealand, the Inland Revenue Department (IRD) allows depreciation on certain items to be claimed as a type of expense for income tax, so it is beneficial to understand what it can be applied to.
In accountancy, depreciation refers to two aspects of the same concept:
1. The decrease in value of assets
2. The allocation of the cost of assets to periods in which the assets are used
Depreciation is a method of reallocating the cost of a tangible asset over its life span. So if, for example, a depreciable asset cost you $1,500 and its life span is 10 years, you can claim depreciation on a straight line basis of $150 per year as an expense.
As far as property investors are concerned, residential rental properties are made up of three items: land, buildings and chattels. Land cannot be depreciated. Buildings and chattels, on the other hand, can be.
Buildings are depreciable assets. However, since 1st April 2011 the IRD does not allow you to claim depreciation on buildings with an estimated life of 50 years or more. This safely covers all the standard rental properties. So, as a property investor, it is important to consider chattels depreciation.
Any item that is separate to the building should be considered a chattel and depreciable. To determine what is considered to be a depreciable chattel, consider the following:
1. If the item is not attached to the building, then it can be depreciated separately.
2. If the item is an integral part of or firmly attached to the building, then it is considered to be a part of the building and cannot be depreciated.
In 2011, the IRD released a list of items that qualify as chattels and are, therefore, depreciable. The list includes things like appliances, drapes, furniture etc.
Chattels useful life
Depreciation is an allowance for the reduction in the value of an asset over its lifetime. Each chattel has its own economic life and can be depreciated separately. Some assets may be depreciated over 3 years, others over 12.5.
Identifying the cost
To maximise your depreciation deductions and to reduce tax at the end of the year, you need to accurately identify the cost of each chattel.
1. Brand new asset
If you have purchased a new chattel, then the cost will be easy to identify. The cost will be the price paid.
2. Purchasing a property with existing chattels
If you have purchased an existing property, then it is probable you have gained many assets, such as blinds, carpets, TV aerials, air conditioners etc.
To accurately work out the cost of the depreciable assets, it is advisable to use a professional chattel valuation expert. A chattel valuation normally costs circa $500, and the benefit of a professional chattel valuation is likely to outweigh the cost.
The valuer will identify the various assets that can be separated from the building structure for depreciation purposes, allocate a value and apply the correct depreciation rates as specified by IRD, which in turn maximises your depreciation claim and therefore your cash flow. You will receive a report identifying the chattels, their values and the IRD depreciation rates.
The benefit will vary from property to property. The newer the property, the higher the value of the chattels, the more benefit there is likely to be. A valuation must be completed within six months of purchasing your rental and before you submit your tax return.
3. Purchasing an old property with outdated chattels
If you have purchased an old, run-down property, with old outdated chattels, then doing a professional valuation is probably not worth it.
It should be noted that if you eventually sell your rental property, you may be subject to depreciation recovery if the amount of depreciation claimed exceeds the actual value at the time of sale. If this is the case, you will need to pay tax on the difference.
Note that it is not compulsory to claim depreciation on your residential rental property chattels, but you must inform IRD if you elect not to. Otherwise, when you sell the property it will be deemed that depreciation has been claimed and you will have to pay tax on that amount. Of course, as mentioned above, for most property investors we believe it is worth claiming depreciation.