The Power of Non-Cash Deductions
Most people understand negative gearing: your property expenses exceed your rental income, and the shortfall is deductible against your other income, reducing your tax bill. But within this strategy, depreciation occupies a unique and particularly powerful position.
Here's why: depreciation is a non-cash deduction. You don't write a cheque or transfer money anywhere. Your bank balance doesn't change. But your taxable income goes down — potentially by thousands of dollars per year.
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A Simple Example
Let's say you own a residential investment property:
Income:
- Rental income: $32,000/year ($615/week)
- Loan interest: $28,000
- Property management: $2,400
- Council rates: $1,800
- Insurance: $1,200
- Repairs and maintenance: $800
- Total cash expenses: $34,200
Now add depreciation:
- Division 43 (capital works): $5,500/year
- Division 40 (plant & equipment): $2,800/year
- Total depreciation: $8,300/year
The difference? $3,071 in additional tax savings — every year — without spending a single extra dollar.
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The True Cash Flow Position
One of the most misunderstood aspects of negatively geared properties is the true cash flow position once tax is considered.
Pre-depreciation:
- Cash outgoing per year: $34,200
- Cash incoming (rent): $32,000
- Real cash shortfall: $2,200
- Loss: $2,200
- Tax benefit: $814
- Net cost after tax: $1,386/year ($27/week)
- Loss: $10,500
- Tax benefit: $3,885
- Cash portion of tax benefit (from $8,300 non-cash depreciation): $3,071 extra in tax refund
- Net cost after tax: approximately $814 less than without depreciation ($1,386 − $3,071 = effectively positive)
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Why This Matters for Your Borrowing Strategy
Lenders assess your ability to service a loan based on cash flow. But your tax accountant and financial planner should be looking at the after-tax, after-depreciation position when modelling your portfolio.
Properties with high depreciation (new builds or recently renovated) can generate such significant non-cash deductions that they shift from negatively geared to effectively neutral or even positive cash flow positions on an after-tax basis — while still providing capital growth potential.
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Depreciation and Your Rental Yield
Depreciation doesn't change your rental yield — that's a function of rent and purchase price. But it does significantly affect your net return on investment once tax is considered.
A property with a gross yield of 4% and $8,000 of annual depreciation at a 37% tax rate generates an additional 0.7% of equivalent return (assuming $750,000 purchase price) from the depreciation alone — on top of the yield itself.
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Diminishing Value vs Prime Cost: Which Is Better for Negative Gearing?
For most investors pursuing a negative gearing strategy, diminishing value (DV) is the better choice because:
- It front-loads deductions, giving you the largest deductions in the early years
- In the early years of investment, negative gearing losses are typically largest (loan interest is highest)
- Front-loading depreciation maximises the tax benefit when you're likely at your highest earning years
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Getting Started
The first step is knowing how much depreciation your property generates. Koste's free Tax Depreciation Calculator gives you an instant estimate. For the full picture that your accountant can use at tax time, order a professional schedule — it pays for itself in the first year in almost every case.