Channel Magazine: What exactly is depreciation?
Sean Parsons: I am frequently asked in my job as a chartered accountant and as a director of DABS Consulting Ltd – what is depreciation and why is it beneficial to claim it for commercial property landlords? The term depreciation refers to an accounting method used to allocate the cost of an asset over its useful life. Depreciation represents how much of an asset’s value has been used. It recognises that the typical asset used in a business has a finite life and that property owners are entitled to a tax deduction against rental income to recognise that expense.
CM: What kind of charge is depreciation?
SP: Depreciation is considered a non-cash charge because it doesn’t represent an actual cash outflow. The entire cash outlay is paid initially when an asset is purchased, but the expense is recorded incrementally for financial reporting purposes. This is because assets provide a benefit to the owner over a lengthy period of time, but the depreciation charges still reduce taxable earnings.
CM: How do you assess depreciation, and why?
SP: At DABS Consulting our policy when we purchase a commercial property is to engage an independent registered valuer to assess a separate value for the various components of the building. The valuation report provides a comprehensive schedule of assets with their cost split out between those that are integral to the fabric of the building, such as the structure, and those that can be separately replaced or removed such as awnings or roller doors. The reason we do this is to maximise the after-tax cash return for our investors. For example, where a depreciation claim is made of $100,000, for a taxpayer on the 33% tax rate that represents a cash saving of $33,000 in their annual tax bill.
CM: What depreciation rates do you use?
SP: We adopt Inland Revenue’s standard published depreciation rates as our accounting depreciation rates. In our view they are a fair benchmark for actual wear and tear. Where an asset reaches the end of its useful life and is replaced, the remaining book value of that asset may be able to be written off as a loss on disposal and a deduction claimed.
CM: Has the Covid pandemic had any effects on depreciation?
SP: From 1 April 2020, that is for the 2021 and subsequent financial years, as a Covid relief measure, the Government once again allowed depreciation to be claimed on commercial building structures. It was the case until 31 March 2011 that buildings could be depreciated so the re-introduction of this has provided welcome relief for many landlords.
"Depreciation of building structures is not permitted for residential property and is an example of the favourable tax rules available through investing in commercial property versus residential."
CM: Are there any negative aspects to claiming for depreciation?
SP: Sometimes an unwelcome consequence of claiming depreciation on buildings may arise where the property is sold and the building structure is deemed to have been disposed for a value higher than its depreciated book value. In this event depreciation recovery income arises for the vendor. This income is the difference between the portion of the sale price allocated to the building structure and the book value. This is income to the vendor in the year of sale. We are sometimes asked why would we depreciate a building when the odds are that it will continue to appreciate in value and this depreciation tax benefit will have to be paid back to Inland Revenue? Our answer is, at DABS we manage the properties for our investors with a view to long term ownership. There is a material benefit for the investors in them being able to offset building depreciation against income with the time value of that benefit being significant over, say, a 20-year period. In simple terms, it is better to have a dollar today and repay that dollar later given the time value benefit. This advantage is amplified during times of high inflation because the real cost of repaying the depreciation tax benefit is reduced over time. Sometimes when a property is sold the deemed value of a building may fall below what was paid upon purchase and when this occurs it is not possible to claim depreciation retrospectively.
CM: How does DABS help with commercial property investment and depreciation claims?
SP: The DABS ownership structure is that of a limited partnership being set up for each property. An investor in a property is a limited partner in a partnership with an equity stake based on their capital invested. We prefer the limited partnership structure because it provides a direct pass through of profit and loss to the investors while providing limited liability. This differs to a company structure which may result in losses being retained in the company to be carried forward to offset against future income, meaning there may be many years before the tax benefit of the loss is utilised. We think that for commercial property investment a limited partnership is more “tax efficient”. In the initial stages of ownership, it is not uncommon for depreciation to exceed net rental income allowing a tax loss to pass out to the investors yet with cashflow being maintained at forecast levels. Investors may use the tax loss to offset against their other income. Over time the depreciation claim may reduce depending on the calculation method adopted but it is prudent in our opinion to maximise depreciation at the commencement of the investment.
For further information or to register your interest for the next Limited Partnership, please contact us. You can also register your details via our website.
Lara Weaver, General Manager
m. 021 230 5989
145 Kitchener Road, Milford