Depreciation is a critical factor in calculating your Capital Gains Tax (CGT) liability when selling an investment property. Specifically, the capital works deductions you claim under Division 43 of the ITAA 1997 reduce the property's cost base, potentially increasing your CGT liability.
How Depreciation Impacts Capital Gains Tax
When you sell an investment property, CGT is calculated on the difference between the sale price and the property's cost base. The cost base includes the purchase price plus any costs associated with acquiring, holding, and improving the asset. However, any capital works deductions you have claimed under Division 43 must be subtracted from this cost base. This effectively increases your capital gain and thus your CGT liability. Notably, plant and equipment depreciation (Division 40) does not affect the cost base for CGT purposes.
A common misconception is that all depreciation deductions impact the cost base, but it's specifically the capital works deductions that do. Investors often overlook this, leading to unexpected tax liabilities upon sale.
How This Works in Practice
Consider a 2010-built 3-bedroom house in Geelong, purchased for $700,000. Over the years, you've claimed $30,000 in Division 43 capital works deductions. You sell the property for $950,000. The initial cost base is $700,000, but you must subtract the $30,000 in capital works deductions, reducing it to $670,000. Your capital gain is therefore $950,000 - $670,000 = $280,000. Assuming a 50% CGT discount for holding the property over 12 months, and a 37% marginal tax rate, your CGT liability would be $51,800.
Professional Insight
In our experience, many investors fail to track their capital works deductions accurately, leading to miscalculated cost bases. One thing we frequently see is investors not realising that only Division 43 deductions impact CGT, not Division 40. Also, investors sometimes neglect to account for improvements that can increase the cost base. Finally, misunderstanding the impact of the CGT discount can lead to overestimating tax liabilities.
When Does the Answer Change?
- Post-9 May 2017 Acquisitions: For properties acquired after this date, second-hand plant and equipment can't be depreciated under Division 40, but this doesn't affect CGT as these deductions don't reduce the cost base.
- Pre-1987 Buildings: Properties built before 1987 may have limited or no capital works deductions, affecting the calculation.
- Held in an SMSF: Different tax rates apply, affecting overall CGT calculations.
- Partial Year Sales: If a property is sold partway through a financial year, prorated calculations may apply.
When Should You Seek Professional Advice?
Seek professional advice when determining your property's cost base and potential CGT liability. A Chartered Quantity Surveyor can help ensure all capital works deductions are accurately accounted for, while a tax accountant can provide specific tax strategies. This is especially crucial if you've made improvements to the property or if it's held in a complex ownership structure.