Expenses deductible over a number of income years

There are three types of expenses you may incur for your rental property that may be claimed over a number of income years:

• borrowing expenses
• amounts for decline in value of depreciating assets
• capital works deductions.

Each of these categories is discussed in detail below.

Borrowing expenses

These are expenses directly incurred in taking out a loan for the property. They include loan establishment fees, title search fees and costs for preparing and filing mortgage documents, including mortgage broker fees and stamp duty charged on the mortgage.

Borrowing expenses also include other costs that the lender requires you to incur as a condition of them lending you the money for the property, such as the costs of obtaining a valuation or lender’s mortgage insurance if you borrow more than a certain percentage of the purchase price of the property.

The following are not borrowing expenses:

• insurance policy premiums on a policy that provides for your loan on the property to be paid out in the event that you die or become disabled or unemployed
• interest expenses.

If your total borrowing expenses are more than $100, the deduction is spread over five years or the term of the loan, whichever is less. If the total deductible borrowing expenses are $100 or less, they are fully deductible in the income year they are incurred.

If you repay the loan early and in less than five years, you can claim a deduction for the balance of the borrowing expenses in the year of repayment.

If you obtained the loan part way through the income year, the deduction for the first year will be apportioned according to the number of days in the year that you had the loan.

Deduction for decline in value of depreciating assets

You can deduct an amount equal to the decline in value for an income year of a depreciating asset that you held for any time during the year. However, your deduction is reduced to the extent your use of the asset is for other than a taxable purpose. If you own a rental property, the taxable purpose will generally be for the purpose of producing assessable income.

Some items found in a rental property are regarded as part of the setting for the rent-producing activity and are not treated as separate assets in their own right. However, a capital works deduction may be allowed for some of these items, see Capital works deductions.

How do you work out your deduction?

You work out your deduction for the decline in value of a depreciating asset using either the prime cost or diminishing value method. Both methods are based on the effective life of the asset. The Depreciation and capital allowances tool will help you with the choice and the calculations.

The diminishing value method assumes that the decline in value each year is a constant proportion of the remaining value and produces a progressively smaller decline over time.

For depreciating assets you started to hold on or after 10 May 2006, you generally use the following formula for working out decline in value using the diminishing value method:

Base value (see Note 1) × (days held ÷ 365 (see Note 2)) × (200% ÷ asset's effective life)

Note 1: For the income year in which an asset is first used or installed ready for use for any purpose, the base value is the asset’s cost. For a later income year, the base value is the asset’s opening adjustable value plus any amounts included in the asset’s second element of cost for that year.

Note 2: Can be 366 in a leap year.

This formula does not apply in some cases, such as if you dispose of and reacquire an asset just so the decline in value of the asset can be worked out using this formula.

For depreciating assets you started to hold prior to 10 May 2006, the formula for working out decline in value using the diminishing value method is:

Base value (see Note 1) × (days held ÷ 365 (see Note 2)) × (150% ÷ asset's effective life)

An asset’s cost has two elements. The first element of cost is, generally, amounts you are taken to have paid to hold the asset, such as the purchase price. The second element of cost is, generally, the amount you are taken to have paid to bring the asset to its present condition, such as the cost of capital improvements to the asset. If more than one person holds a depreciating asset, each holder works out their deduction for the decline in value of the asset based on their interest in the asset and not on the cost of the asset itself.

The adjustable value of a depreciating asset is its cost (first and second elements) less its decline in value up to that time. Adjustable value is similar to the concept of undeducted cost used in the former depreciation provisions. The opening adjustable value of an asset for an income year is generally the same as its adjustable value at the end of the previous income year.

The prime cost method assumes that the value of a depreciating asset decreases uniformly over its effective life. The formula for working out decline in value using the prime cost method is:

Asset's cost × (days held ÷ 365 (see Note 2)) × (100% ÷ asset's effective life)

The formula under the prime cost method may have to be adjusted if the cost, effective life or adjustable value of the asset is modified. For more information, see the Guide to depreciating assets 2014.

Under either the diminishing value method or the prime cost method, the decline in value of an asset cannot amount to more than its base value.

If you use a depreciating asset for other than a taxable purpose (for example, you use the same lawn mower at both your rental property and your private residence) you are allowed only a partial deduction for the asset’s decline in value, based on the percentage of the asset’s total use that was for a taxable purpose.

Effective life

Generally, the effective life of a depreciating asset is how long it can be used by any entity for a taxable purpose, or for the purpose of producing exempt income or non-assessable non-exempt income:

• having regard to the wear and tear you reasonably expect from your expected circumstances of use
• assuming that it will be maintained in reasonably good order and condition, and
• having regard to the period within which it is likely to be scrapped, sold for no more than scrap value or abandoned.

Effective life is expressed in years, including fractions of years. It is not rounded to the nearest whole year.

For most depreciating assets you can choose to work out the effective life yourself or to use an effective life determined by the Commissioner of Taxation.

The sort of information you could use to make an estimate of effective life of an asset is listed in the Guide to depreciating assets 2014.

In making his determination, the Commissioner assumes the depreciating asset is new and has regard to general industry circumstances of use.

There are various Taxation Rulings made by the Commissioner regarding how to determine the effective life expectancy of depreciating assets:

• TR 2013/4 is applicable from 1 July 2013
• TR 2012/2 is applicable from 1 July 2012
• TR 2011/2 is applicable from 1 July 2011
• TR 2010/2 is applicable from 1 July 2010
• TR 2009/4 is applicable from 1 July 2009
• TR 2008/4 is applicable from 1 July 2008
• TR 2007/3 is applicable from 1 July 2007
• TR 2006/15 is applicable from 1 January 2007
• TR 2006/5 is applicable from 1 July 2006
• TR 2000/18 is applicable from 1 July 2001

Because the Commissioner often reviews the determinations of effective life, the determined effective life may change from the beginning of, or during, an income year. You need to work out which Taxation Ruling, or which schedule accompanying the relevant Taxation Ruling to use for a particular asset’s determined effective life.

As a general rule, use the ruling or schedule that is in force at the time you:

• entered into a contract to acquire the depreciating asset
• otherwise acquired it, or
• started to construct it.

Immediate deduction for certain non-business depreciating assets costing $300 or less

The decline in value of certain depreciating assets costing $300 or less is their cost. This means you get an immediate deduction for the cost of the asset to the extent that you use it for a taxable purpose during the income year in which the deduction is available.

The immediate deduction is available if all of the following tests are met in relation to the asset:

• it cost $300 or less
• you used it mainly for the purpose of producing assessable income that was not income from carrying on a business (for example, rental income where your rental activities did not amount to the carrying on of a business)
• it was not part of a set of assets costing more than $300 that you started to hold in the income year, and
• it was not one of a number of identical, or substantially identical, assets that you started to hold in the income year that together cost more than $300.

If you hold an asset jointly with others and the cost of your interest in the asset is $300 or less, you can claim the immediate deduction even though the depreciating asset in which you have an interest cost more than $300; see Partners carrying on a rental property business.

 

For more information about immediate deductions for depreciating assets costing $300 or less, see the Guide to depreciating assets 2014.

Low-value pooling

You can allocate low-cost assets and low-value assets relating to your rental activity to a low-value pool. A low-cost asset is a depreciating asset whose cost is less than $1,000 (after GST credits or adjustments) as at the end of the income year in which you start to use it, or have it installed ready for use, for a taxable purpose. A low-value asset is a depreciating asset that is not a low-cost asset and:

• that has an opening adjustable value for the current year of less than $1,000, and
• for which you have worked out any available deductions for decline in value under the diminishing value method.

You work out the decline in value of an asset you hold jointly with others based on the cost of your interest in the asset. This means if you hold an asset jointly and the cost of your interest in the asset or the opening adjustable value of your interest is less than $1,000, you can allocate your interest in the asset to your low-value pool. Once you choose to create a low-value pool and allocate a low-cost asset to it, you must pool all other low-cost assets you start to hold in that income year and in later income years. However, this rule does not apply to low-value assets. You can decide whether to allocate low-value assets to the pool on an asset-by-asset basis.

Once you have allocated an asset to the pool, it remains in the pool.

Once an asset is allocated to a low-value pool it is not necessary to work out its adjustable value or decline in value separately. Only one annual calculation for the decline in value for all of the depreciating assets in the pool is required.

You work out the deduction for the decline in value of depreciating assets in a low-value pool using a diminishing value rate of 37.5%.

For the income year you allocate a low-cost asset to the pool, you work out its decline in value at a rate of 18.75%, or half the pool rate. Halving the rate recognises that assets may be allocated to the pool throughout the income year and eliminates the need to make separate calculations for each asset based on the date it was allocated to the pool.

When you allocate an asset to the pool, you must make a reasonable estimate of the percentage of your use of the asset that will be for a taxable purpose over its effective life (for a low-cost asset) or the effective life remaining at the start of the income year for which it was allocated to the pool (for a low-value asset). This percentage is known as the asset’s taxable use percentage.

It is this taxable use percentage of the cost or opening adjustable value that is written off through the low-value pool.

For further information about low-value pooling, including how to treat assets used only partly to produce assessable income and how to treat the disposal of assets from a low-value pool, see the Guide to depreciating assets 2014.

If you are an individual who owns or has co-ownership of a rental property, you claim your low-value pool deduction for rental assets at item D6 on your tax return, not at item 21 on your tax return.

What happens if you no longer hold or use a depreciating asset?

If you cease to hold or to use a depreciating asset, a balancing adjustment event will occur. If there is a balancing adjustment event, you need to work out a balancing adjustment amount to include in your assessable income or to claim as a deduction.

A balancing adjustment event occurs for a depreciating asset if:

• you stop holding it, for example, if the asset is sold, lost or destroyed
• you stop using it and expect never to use it again
• you stop having it installed ready for use and you expect never to install it ready for use again
• you have not used it and decide never to use it, or
• a change occurs in the holding or interests in an asset which was or is to become a partnership asset.

You work out the balancing adjustment amount by comparing the asset’s termination value (such as the proceeds from the sale of the asset) and its adjustable value at the time of the balancing adjustment event. If the termination value is greater than the adjustable value, you include the excess in your assessable income. If you are an individual who owns or has co-ownership of a rental property, you show such assessable amounts at item 24 Other income on your tax return and not at item 21.

If the termination value is less than the adjustable value, you can deduct the difference.

For more information about balancing adjustments, see the Guide to depreciating assets 2014.

If a balancing adjustment event happens to a depreciating asset that you used at some time other than for income-producing purposes (for example, privately) then a capital gain or capital loss might arise to the extent that you so used the asset.

For more information about capital gains tax and depreciating assets see the Guide to depreciating assets 2014.

Purchase and valuation of second-hand assets

If you purchase a second-hand asset you can generally claim a deduction based on the cost of the asset to you.

Where you purchase a rental property from an unrelated party, one objective means of establishing your cost of depreciating assets acquired with the property is to have their value, as agreed between the contracting parties, specified in the sale agreement. If separate values for depreciating assets are not included in the sale agreement for your rental property when you purchase it, you may be required to demonstrate the basis of your valuation.

Generally, independent valuations that establish reasonable values for depreciating assets satisfy ATO requirements. In the absence of an independent valuation, you may need to demonstrate that your estimate provided a reasonable value. Considerations would include the market value of the asset compared to the total purchase price of the property.

Working out your deductions for decline in value of depreciating assets

Following are two examples of working out decline in value deductions. The Guide to depreciating assets 2014 contains two worksheets (Worksheet 1: Depreciating assets and Worksheet 2: Low-value pool) that you can use to work out your deductions for decline in value of depreciating assets.

Capital works deductions

You can deduct certain kinds of construction expenditure. In the case of residential rental properties, the deductions would generally be spread over a period of 25 or 40 years. These are referred to as capital works deductions. Your total capital works deductions cannot exceed the construction expenditure. No deduction is available until the construction is complete.

Deductions based on construction expenditure apply to capital works such as:

• a building or an extension, for example, adding a room, garage, patio or pergola
• alterations, such as removing or adding an internal wall
• structural improvements to the property, for example, adding a gazebo, carport, sealed driveway, retaining wall or fence.

You can only claim deductions for the period during the year that the property is rented or is available for rent.

If you can claim capital works deductions, the construction expenditure on which those deductions are based cannot be taken into account in working out any other types of deductions you claim, such as deductions for decline in value of depreciating assets.

Amount of deduction

The amount of the deduction you can claim depends on the type of construction and the date construction started.

Table 1 below shows you the types of rental property construction that qualify. If the type of construction you own (or own jointly) does not appear next to the relevant ‘date construction started’ in the Table, you cannot claim a deduction. If the type of construction qualifies, Table 2 shows the rate of deduction available.

Table 1 – Types of rental property construction that qualify for deduction

Date construction started	Type of construction for which deduction can be claimed
Before 22 August 1979	None
22 August 1979 to 19 July 1982	Certain buildings (see Note 4) intended to be used on completion to provide short-term accommodation to travellers (see Note 5)
20 July 1982 to 17 July 1985	Certain buildings(see Note 4) intended to be used on completion to provide short-term accommodation to travellers (see Note 5)
	Building intended to be used on completion for non-residential purposes (for example, a shop or office)
18 July 1985 to 26 February 1992	Any building intended to be used on completion for residential purposes or to produce income
27 February 1992 to 18 August 1992	Certain buildings (see Note 4) intended to be used on completion to provide short-term accommodation to travellers (see Note 5)
	Any other building intended to be used on completion for residential purposes or to produce income
	Structural improvements intended to be used on completion for residential purposes or to produce income
19 August 1992 to 30 June 1997	Certain buildings (see Note 4) intended to be used on completion to provide short-term accommodation to travellers (see Note 5).
	Any other building intended to be used on completion for residential purposes or to produce income
	Structural improvements intended to be used on completion for residential purposes or to produce income
	Environment protection earthworks (see Note 5) intended to be used on completion for residential purposes or to produce income
After 30 June 1997	Any capital works used to produce income (even if, on completion, it was not intended that they be used for that purpose)

Note 4: ‘Certain buildings’ are apartment buildings in which you own or lease at least 10 apartments, units or flats; or a hotel, motel or guest house that has at least 10 bedrooms.

Note 5: For more information, phone 13 28 66.

Table 2 – Rate of deduction based on date construction started

Date construction started	Rate of deduction per income year
Before 22 August 1979	nil
22 August 1979 to 21 August 1984	2.5%
22 August 1984 to 15 September 1987	4%
After 15 September 1987	2.5%

Note 6: Where construction of a building to provide short-term accommodation for travellers commenced after 26 February 1992, the rate of deduction was increased to 4%.

For apartment buildings, the 4% rate applies to apartments, units or flats only if you own or lease 10 or more of them in the building.

The deduction can be claimed for 25 years from the date construction was completed in the case of a 4% deduction, and for 40 years from the date construction was completed in the case of a 2.5% deduction. If the construction was completed part of the way through the income year, you can claim a pro-rata deduction for that part.

Construction expenditure that can be claimed

Construction expenditure is the actual cost of constructing the building or extension. A deduction is allowed for expenditure incurred in the construction of a building if you contract a builder to construct the building on your land. This includes the component of your payments that represents the profit made by individual tradespeople, builders and architects. If you are an owner/builder, the value of your contributions to the works, for example, your labour and expertise, and any notional profit element do not form part of the construction expenditure.

If you purchase your property from a speculative builder, you cannot claim the component of your payment that represents the builder’s profit margin as a capital works deduction.

Some costs that you may include in construction expenditure are:

• preliminary expenses such as architects’ fees, engineering fees and the cost of foundation excavations
• payments to carpenters, bricklayers and other tradespeople for construction of the building
• payments for the construction of retaining walls, fences and in-ground swimming pools.

Construction expenditure that cannot be claimed

Some costs that are not included in construction expenditure are:

• the cost of the land on which the rental property is built
• expenditure on clearing the land prior to construction
• earthworks that are permanent, can be economically maintained and are not integral to the installation or construction of a structure
• expenditure on landscaping.

Changes in building ownership

Where ownership of the building changes, the right to claim any undeducted construction expenditure for capital works passes to the new owner. A new owner should confirm that the building was constructed during one of the appropriate periods outlined in Table 1. To be able to claim the deduction, the new owner must continue to use the building to produce income.

Estimating construction costs

Where a new owner is unable to determine precisely the construction expenditure associated with a building, an estimate provided by an appropriately qualified person may be used. Appropriately qualified people include:

• a clerk of works, such as a project organiser for major building projects
• a supervising architect who approves payments at stages of projects
• a builder who is experienced in estimating construction costs of similar building projects
• a quantity surveyor.

Unless they are otherwise qualified, valuers, real estate agents, accountants and solicitors generally have neither the relevant qualifications nor the experience to make such an estimate.

The cost of obtaining an appropriately qualified person’s estimate of construction costs of a rental property is deductible in the income year it is incurred. You make your claim for the expense, or your share of the expense if you jointly incurred it, at item D9 Cost of managing tax affairs on your tax return.

For more information about construction expenditure and capital works deductions, see Taxation Ruling TR 97/25 – Income tax: property development: deduction for capital expenditure on construction of income producing capital works, including buildings and structural improvements and Rental properties – capital works deductions

Cost base adjustments for capital works deductions

In working out a capital gain or capital loss from a rental property, the cost base and reduced cost base of the property may need to be reduced to the extent that it includes construction expenditure for which you have claimed or can claim a capital works deduction.

Cost base

You must exclude from the cost base of a CGT asset (including a building, structure or other capital improvement to land that is treated as a separate asset for CGT purposes, refer to Note 7) the amount of capital works deductions you have claimed or can claim in respect of the asset if:

• you acquired the asset after 7.30pm (by legal time in the ACT) on 13 May 1997, or
• you acquired the asset before that time and the expenditure that gave rise to the capital works deductions was incurred after 30 June 1999.

Note 7: For information on when a building, structure or other capital improvement to land is treated as a CGT asset separate from the land, see chapter 1 and the section Major capital improvements to a dwelling acquired before 20 September 1985 in the Guide to capital gains tax 2014.

Reduced cost base

The amount of the capital works deductions you have claimed or can claim for expenditure you incurred in respect of an asset is excluded from the reduced cost base.

For more information about whether you can claim certain capital works deductions, see Taxation Determination TD 2005/47 – Income tax: what do the words ‘can deduct’ mean in the context of those provisions in Division 110 of the Income Tax Assessment Act 1997 which reduce the cost base or reduced cost base of a CGT asset by amounts you ‘have deducted or can deduct’, and is there a fixed point in time when this must be determined and Law Administration Practice Statement (General Administration) PS LA 2006/1 (GA) – Calculating the cost base and reduced cost base of a CGT asset if a taxpayer does not have sufficient information to determine the amount of construction expenditure on the asset for the purpose of working out their entitlement to a deduction under Division 43 of the Income Tax Assessment Act 1997.

Limited recourse debt arrangements

If expenditure on a depreciating asset (which includes construction expenditure) is financed or refinanced wholly or partly by limited recourse debt (including a notional loan under certain hire purchase or instalment sale agreements of goods), you must include excessive deductions for the capital allowances as assessable income. This will occur where the limited recourse debt arrangement terminates but has not been paid in full by the debtor. Because the debt has not been paid in full, the capital allowance deductions, including capital works deductions, allowed for the expenditure exceed the deductions that would be allowable if the unpaid amount of the debt was not counted as capital expenditure of the debtor. Special rules apply for working out whether the debt has been fully paid.

If you are not sure what constitutes a limited recourse debt or how to work out your adjustment to assessable income, contact your recognised tax adviser.