Rental property depreciation

WITH MARY HOLM

Q. To further clarify the position on repayment of depreciation, which you outlined in your August 24 column, can you please comment on this example. I've simplified the figures for ease of understanding.

If I get, say, $5000 written off the value of a rental property each year for five years, that gives me a total of $25,000.

Does that mean that if I sell after five years, and I am on the lowest tax rate of 19.5 per cent (say 20 per cent), I only pay $5000 in tax upon the sale of the house?

I always thought I would have to pay the number of actual dollars I had claimed and that the benefit to me was that a dollar today is worth more than a dollar tomorrow.

If I only have to repay one-fifth of the money the IRD gave me, that feels like a gift of $20,000!

Of course, I'm assuming the selling price will be well above the purchase price, and therefore the whole sum of $25,000 comes into play.

No wonder my accountant says I should claim depreciation.

My natural inclination is not to do so, as the day I sell I don't want to have to pay the IRD as well as the real estate man.

A. Sorry, but there's no $20,000 gift.

You're right to say you would have to pay only $5000 on the sale of the house. But that's because the depreciation you've claimed over the years benefited you by only $5000.

Your mistake is that you're putting too much value on your depreciation deduction.

All tax deductions are subtracted from taxable income, so that you end up being taxed on your net profit, after expenses.

In your example, each year you deduct depreciation of $5000. That cuts your taxable income by $5000. If you're in the 20 per cent tax bracket, you have avoided paying tax of 20 per cent of $5000, which is $1000.

Over the five years, then, you've avoided paying tax of $5000. And, if you sell for more than your purchase price and stay in the same tax bracket, that's the amount that gets clawed back.

The only advantage is, as you say, that a dollar today is worth more than a dollar tomorrow.

Things get a bit more complicated, though, if you change tax brackets.

Assume, for instance, that you're in the 33 per cent bracket while you own the property. For every $5000 you deduct in depreciation you will avoid paying tax of $1650.

Then you move into our made-up 20 per cent bracket, and later sell the property at a profit.

You add all your claimed depreciation to your taxable income.

But because you are now taxed at a lower rate, the total tax you pay will be $1000 - not as much as the tax avoided over the years.

The reverse would be true if you are in a higher tax bracket when you sell. The clawback would then be bigger than the tax avoided.

Q. I was interested in your reply to the letter regarding depreciation clawback on rental properties.

We own a mortgage-free property with a small (removable) cottage on it. We have been renting the property for the past six years and making the appropriate tax claims on it.

The cottage valuation is only 30 per cent of the current Government valuation.

Could you tell me if the same depreciation clawback rules apply if we follow our current plan to eventually remove that cottage and build a home for ourselves on that land?

A. It depends on how much depreciation you have claimed and how much you get for the house from the removal company, says Chris Abbiss, KPMG's partner in charge of tax.

Your accountant will have set a value for the cottage when you started claiming depreciation.

Let's say you paid $100,000 for the property, of which $30,000 was for the cottage, and the rest was for the land.

And we'll say you remove the cottage in four years' time - 10 years after you bought the property.

Under the rules for property bought after 1993, you will probably have depreciated 4 per cent of the cottage value, or $1200, each year. That comes to a total of $12,000 over the 10 years.

So the book value of the cottage will be $18,000 ($30,000 minus $12,000).

If you sell the cottage for more than its original $30,000 value, all of the $12,000 of depreciation you have claimed will be clawed back.

If you sell for, say, $27,000, the difference between that and the $18,000 book value will be clawed back.

If you sell for less than the $18,000 book value, there will be no clawback. The cottage has, indeed, dropped in value - and, in fact, by more than you put in the accounts.

You can't, though, claim for that loss, says Abbiss.

Nor can you speed up your depreciation in the meantime. You're stuck with the rate the IRD sets, he says.

He adds that if you're also depreciating chattels, such as carpet and appliances, you will have to account for those separately.

"They will have been depreciated at higher rates.

"You have to do the same sort of calculations for them," says Abbiss.

Note that if there is a clawback, you add that amount to your taxable income.

It doesn't mean you pay that full amount to the IRD, just the tax on that amount.

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