Martin Hawes: Depreciation loses lustre

Politicians are not saying so yet, but it looks certain that, quite soon, property investors will not be able to claim depreciation. There is a national debate on this already, and I thought maybe it was a good idea to remind ourselves why depreciation is important to property investors.

Property investors are deemed to be in business. When you buy an investment property, you buy three things: the land, the building and chattels (carpet, drapes, appliances, etc). The building and the chattels are depreciated at different rates and for a property investor, the total claims can add up to many thousands of dollars.

Property investors' biggest problem for the past few years has been cash flow or, more accurately, the lack of it.

The investor usually has a cash deficit on the property - interest and other expenses are greater than rent. However, when depreciation is claimed, the loss for tax purposes can be huge and this loss is offset against other income (eg salary), resulting in a large tax refund. This tax refund often means the rental property cash deficit turns into a cash surplus.

I have never properly understood why property investors are so keen on making a loss. Sure there is a tax refund but my basic rule is that you are better to make a profit and pay some tax than make a loss and pay no tax.

In reality, most property investors are so desperate for cash flow that they do not think about long-term value. In many cases, depreciation is real enough and although the tax refund for being able to claim depreciation on the carpet may help cash flow and pay loan costs, the carpet does indeed deteriorate and will need to be replaced sooner or later.

Claiming depreciation is therefore only a temporary cash flow fix, not a permanent solution to investment difficulties.

This is particularly so when you remember any depreciation claimed that turns out not to be real must be repaid to the IRD when the property is sold. In this respect, the investor gets a temporary cash flow advantage but the positive cash flow is not genuine profit.

One day either the carpet will need to be replaced or the depreciation will have to be repaid - depreciation claims and tax refunds are not a permanent solution to cash flow difficulties.

Property investors will rail against the elimination of deductible depreciation but in the long term it may turn out to be a good thing. Investment 101 says tax should never be a reason for an investment because the rules can change. When depreciation on property is abolished, investors will have to look at the real numbers behind their investments (especially rental yields), not the fake temporary ones that have been produced by tax refunds. That ought to make them more astute investors.

The real problem with residential property is that it is not a good investment - rental income is too low. A tax refund from depreciation may mask that problem, but does not turn a poor investment into a good one.

Martin Hawes is a financial adviser. His disclosure statement can be found at www.wealthcoaches.net