Converting primary residence to rental property

Converting Primary Residence To Rental Property Depreciation

When a homeowner decides to convert their primary residence to a rental property, they enter into a complex financial process that requires careful consideration of various tax implications.

One such implication is the depreciation of the property, which can have significant consequences for both the homeowner and their tenants.

Depreciation refers to the gradual decrease in value of the structural items and plant and equipment within a property over time due to wear and tear, age, and other factors.

As such, the decline in value is considered an ‘on paper’ expense that can be deducted from taxable income.

However, when it comes to converting a primary residence to a rental property, homeowners must navigate several rules and regulations regarding depreciation that can impact their tax liability and overall profitability.

Capital gains tax is a big item and will be covered in depth later.

This article will explore these rules in detail and provide guidance on how homeowners can maximise their depreciation deductions while avoiding common pitfalls.

What Is Real Estate Depreciation?

Real estate depreciation refers to the decrease in value of a rental property over time due to wear and tear and scrapping.

Depreciation is a tax deduction allowing real estate investors to deduct a portion of the cost of their rental property from their income taxes each year. This deduction is marked off against the rental income to help reduce the tax payable.

For instance, if an individual converts their primary residence into a rental property, they can claim depreciation on the portion of the home used for rental purposes.

This is because rental properties are considered income-generating assets and are subject to taxation on the income earned.

Tax depreciation can help offset this tax burden, making it an important aspect of real estate investment.

How does tax depreciation work on a principal property

When converting a primary residence to rental property, this tax benefit also applies. The ATO allows property owners to depreciate the value of their rental property over the duration of the rental period. This may be just 1-year or for the rest of the owner’s life. So substantial tax savings can be found over the long term.

It’s important to note that only the building and assets are subject to depreciation. Not the land on which it stands. Additionally, if the property owner makes any improvements or renovations to the rental property, they may also be eligible for additional depreciation deductions.

Overall, understanding how depreciation works when converting a primary residence to rental property can help property owners maximise their tax benefits and minimise their tax liabilities.

Benefits Of Real Estate Depreciation

Real estate depreciation is a significant tax benefit for property owners who have rental properties.

Depreciation allows property owners to deduct the cost of their rental property over several years, reducing their taxable income and lowering tax liability.

This deduction is based on the idea that buildings and improvements to land decrease in value over time, so taxpayers can take advantage of this loss by claiming it as a tax deduction.

By claiming depreciation, landlords can offset rental income and reduce their overall tax burden.

Additionally, real estate depreciation is an excellent way for landlords to increase cash flow since they can use the money saved from lower taxes to reinvest in their property or pay down debt.

Overall, real estate depreciation is a valuable tool for rental property owners looking to maximise their tax benefits and improve their financial situation without sacrificing their investments’ long-term profitability.

Capital Gains tax (CGT) on your principal property

In Australia, the 6-year rule is a capital gains tax (CGT) exemption that applies to the sale of a person’s primary residence. If a person sells their main residence and they have lived in it for at least 6 years, they can avoid paying capital gains tax under certain circumstances. Here’s how the rule works:

  • Main residence: The property in question must be the owner’s primary place of residence, which means they must have lived in it for a substantial period of time. This is different from an investment property or a secondary home.
  • 6-year period: If the owner has lived in the property as their primary residence for at least 6 years, they may be eligible for a full CGT exemption upon the sale of the property.
  • Absence: The rule also applies if the owner has been absent from their primary residence for a period of up to 6 years. During this time, the owner can still claim the property as their main residence for CGT purposes, provided they do not claim another property as their primary residence during that period. This is particularly useful if the owner moves overseas temporarily or lives in another property for a while.
  • Multiple absences: The owner can use the 6-year rule multiple times, provided the total period of absence does not exceed 6 years. If they move back into the property, the 6-year period resets, and they can potentially claim the exemption again in the future.
  • Partial exemption: If the owner does not meet the full 6-year requirement, they may still be eligible for a partial CGT exemption, which would be calculated based on the proportion of time the property was their primary residence.
  • Proceeds of the sale: If the owner sells their main residence and meets the conditions of the 6-year rule, they can use the proceeds from the sale to purchase another property without incurring capital gains tax.

Keep in mind that tax regulations can change, and individual circumstances can vary. It’s always a good idea to consult with a professional tax advisor for specific advice related to your situation.

Frequently Asked Questions

Can You Claim Depreciation On A Primary Residence That Has Never Been Rented Before?

Yes. Any property is eligible. To claim the tax deductions all you need do is have the property listed as available for rent and for the property to be vacant and ready for tenants to move in.

Are There Any Restrictions On How Much Depreciation Can Be Claimed On A Rental Property?

You can claim as much as the value of the property in the sense of the original construction costs.
That means, if your house cost $300,000 to build, then you can claim that $300,000 in tax deductions (over many years).

Note: The ATO states a building has a life of 40-years. So renting out a ten year old home would mean 25% of the $300,000 has now lapsed and can’t be depreciated.
Fortunately, the remaining 75% still can.

Additionally, property built before September 1987 can’t claim deductions for the original construction costs.
But they can claim for any renovations carried out after that date.

Have any Questions?

Simply get in touch with me here and I’ll personally address any questions you have.

Particularly if you are new to investment property ownership. I’ll happily share some tips with you.

If you found this helpful, you may also find some of my other articles beneficial too. And to see some real life examples of what our clients have been receiving in tax depreciation deductions, check out our Client Portfolio page. But it’s usually best to start at the beginning by visiting our home page

This article was written by William Callaghan A.A.I.Q.S.
2nd generation Quantity Surveyor and founder of WRC Quantity Surveying

Published April 2023