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Since 1 July 2017, there have been specific rules for deductions for decline in value of certain second-hand depreciating assets in a residential rental property under Division 40 (section 40-27). 

These rules sates that if a taxpayer uses these second hand assets to produce rental income from residential rental property (not a commercial property), they cannot claim a deduction for their decline in value unless they are using the property in carrying on a business, or they are an excluded entity which includes entities like companies. 

Second-hand depreciating assets are these depreciating assets:

1. First, the taxpayer is not the first entity that used the asset, other than as trading stock. Retailers and developers will sell new depreciable assets as trading stock so deductions will be available for these assets. For retailers the owner will has purchased the depreciable asset directly so will not be able to use an estimate as the cost of the good.

• Second, the asset is used or installed ready for use in the residence of the taxpayer for any time. Once a taxpayer has installed a depreciable asset in their residence, they can never depreciate it ever again.

• Third, the asset is used or installed ready for use for a purpose that is not a taxable purpose, other than incidental or occasional use. This will mean a taxpayer staying at their rental property at the beach will ensure no depreciation deductions ever again on the assets in the beach house, even if it is rented out later. However, this will not occur if the private use of the beach house is merely incidental or occasional. 

What is incidental or occasional use? How long can I stay at my holiday house before I can no longer claim depreciation on the new assets I bought at Harvey Norman? Here are the two examples the Government has given us:

For example, spending a weekend in a holiday home or allowing relatives to stay for one weekend in the holiday home free of charge that is usually used for rent would generally be occasional use

One weekend!!! And it also states:

staying at the property for one evening while carrying out maintenance activities would generally be incidental use.

One night!! Ouch!!

It is fundamental to warn clients of the consequences of spending a week at their rental property down at the beach before they lose their depreciation deductions.

Exceptions…

There are two of exceptions to this new rule of no depreciation deductions if the asset was “previously used”.  

Exception to the “previously used” rule – Certain entities

The first is this rule does not apply to these entities:

• An entity that is using the asset in carrying on a business (owning a rental property is not a business, owning 10 rental properties is not a business, owning … rental properties is not a business if it is no taking up much of your time managing them);
• The taxpayer Is a corporate tax entity; or
• The taxpayer is a certain type of institutional investor like a Managed Investment Trust, a Public Trading Trust or a Super Fund that is not a Self Managed Super Fund.

Simply, it will be rare that this exception applies.

Exception to the “previously used” rule – New residential premises

There is an additional exception such that these changes will not apply to an asset installed in premises supplied as new residential premises, but only if:

• No one resided in residential premises in which the asset has been used before it was held by the current owner; or

• The asset was used or installed in new residential premises that were supplied to the taxpayer within six months of the premises becoming new residential premises, and the asset had not been previously used or installed in a residence.

Why is there this 6-month rule? Allowing entities to access the exception for assets only used or installed in new residential premises supplied within six months of the premises becoming new residential premises ensures that entities acquiring tenanted apartments are not disadvantaged.

What about assets installed in the common property of apartment complexes of new residential premises? Have they been “previously used” by the first tenant? As the asset is not used in residential premises, the owner may deduct amounts for the decline in value of such assets reflecting the extent of their ownership of the asset unless:

• A previous owner of the same unit or apartment deducted amounts related to depreciation of the asset; or

• The asset has been previously used or installed ready for use in residential premises that were being used as a residence.

But remember you can still lose the depreciation deductions on assets if you do either of the following:

• Make the residential premises your residence for any time; or

• Use the residential premises for a purpose that is not a taxable purpose, other than incidental or occasional use. This will mean a taxpayer staying at their rental property at the beach will mean now more depreciation deductions ever again on the assets in the beach house, even if it is rented out later. However, this will not occur if the private use of the beach house is merely incidental or occasional. 

So even depreciable asset purchased in new residential premises can become ineligible for depreciation deductions.

What if I owned the rental property before these changes?

If the property was purchased before 10 May 2017 AND if I look at your tax return I can see you claimed deductions on the property as a rental property for some time in the 2016/17 tax year then these changes don’t apply. If you pass this test, you can claim Division 40 depreciation deductions on second hand depreciable assets you owned in the property before 1 July 2017.

Example 

Craig has acquired an apartment that he intends to offer for rent. This apartment is three years old and has been used as a residence for most of this time.

Craig acquires a number of depreciating assets together with the apartment, including carpet that was installed by the previous owner. He also acquires a number of depreciating assets to install in the apartment immediately prior to renting it out, including:

• curtains, which he purchases new from Retailer Co; and
• a washing machine, that he purchases used from a friend, Jo.

Craig also purchases a new fridge, but rather than place this in the apartment, he uses it to replace his personal fridge, that he acquired a number of years ago for use in his residence. He instead places his old fridge in the new apartment.

Craig cannot deduct an amount under Division 40 for the decline in value of the carpet, washing machine or fridge for their use in generating assessable income from the use of his apartment as a rental property as both are previously used. The carpet and washing machine are previously used as the previous owner or Jo rather than Craig first used or installed the assets (other than as trading stock). The fridge is previously used as while Craig first used or installed the fridge, he has used it in premises that were his residence at that time.

Craig can deduct an amount under Division 40 for the decline in value of the curtains. They are not ‘previously used’ under either limb of the definition.But as Craig bought the curtains from a retailer he knows what they cost so cannot use an estimated cost in a tax depreciation schedule.

Example 

Hannah purchases two apartments off the plan from Developer Co. The apartments are supplied three months after completion – one is already tenanted and the other is vacant.

In addition to the construction of the apartments, Developer Co has fitted out the apartments, installing ready for use depreciating assets including curtains and furniture prior to settlement and the transfer of the title to Hannah. Developer Co has also fitted out the shared areas of the complex in which the apartment is located, installing ready for use a range of deprecating assets that are the joint property of the apartment owners.

All of these assets are new at the time of installation. These assets were first installed by Developer Co, not Hannah. However, a deduction is still available to Hannah for the depreciating assets (including Hannah’s share of the assets installed in the shared areas of the apartment) for the period she holds the assets as:

• The assets have been installed ready for use in premises that were supplied to Hannah as new residential premises or in other real property supplied as part of the supply of residential premises;
  
• Developer Co has not claimed any deduction for the decline in value of the assets (and nor has any other entity); and
  
• either (excluding assets installed in the common property):
  
  • for assets in the first apartment, the assets were only used or installed in the apartment, which was supplied to Hannah as new residential premises within six months of the apartment first becoming residential premises; or
    
  • for assets in the second apartment, no entity has resided in residential premises in which the assets have been installed before Hannah held the assets. 

Capital Loss schedules – Generally not worth anything to the taxpayer

Where the depreciation deductions are denied under the above change, if the depreciable asset is sold or scrapped for a loss, this will create a capital loss.

For example, if I buy a rental property for $500,000 and I get a tax depreciation schedule that says the building and land is worth $480,000 and the depreciable assets are worth $20,000, if in three years time, I scrap all the depreciable assets I get a $20,000 capital loss if I was unable to depreciate these assets because of the rules above (section 40-27)…

But before we get too excited… remember that a capital loss can only be applied against capital gains so if you don’t have any capital gains the loss is worthless.

But before we get too excited… remember that the way I got the $20,000 capital loss was by reducing the cost base of the building and land by $20,000. Therefore, when you sell the land and building I will have increased the capital gain by $20,000. I am increasing the gain on the land and building by the same amount as the loss I am creating… which in most cases will be of no benefit at all!

Example:

Tom buys a rental property and under the new rules he cannot claim any Division 40 deductions.

He is told to get a tax depreciation schedule to work out what will be the capital loss on the depreciable assets when he sells the rental property and the report comes back and says of the $500,000 he spent on buying the rental property, $20,000 related to depreciable assets.

Tom therefore treats the cost of the building as $480,000, and from the depreciation schedule says he spent $20,000 on depreciable assets.

Tom sells the rental property for $600,000 two years later and states he sold the land and building for $600,000 and the depreciable assets for $0. Tom therefore makes a $20,000 capital loss on the depreciable assets. But he also makes a $120,000 ($600,000 less $480,000) capital gain on the land and building. The net effect is a capital gain of $100,000.

Tom then realises that if he had not have paid for the depreciation schedule he would have treated the $500,000 he paid when he bought the land and buildings and when he sold the land and buildings for $600,000 he would make a $100,000 capital gain.

Exactly the same outcome. Tom now wants a refund of the fee he paid for the schedule.

Many (possibly most) owners of rental properties will just decide to treat the entire purchase price as the price for the land and buildings as capital gains will only arise when they sell the property.

The only possible potential benefit in getting a Capital Loss schedule is if you scrap the depreciable assets years before you sell the property as the capital loss arises in the year you scrap. But as capital losses can only be offset against capital gains you only get to use the capital losses when you sell something else that has a capital gain… and in many cases this will be the sale of the rental property in a few years time. Once again, no benefit in getting the schedule. And even if there is a benefit, it is merely using the capital loss in an earlier year, so not much of a benefit.