One of the questions we are frequently asked by property investors — particularly those considering selling — is how the depreciation deductions they have claimed over the years will affect their Capital Gains Tax (CGT) liability. It is a legitimate and important question, and the interaction between depreciation and CGT is an area where good professional advice can save you from a costly surprise.
What is the Cost Base?
When you sell an investment property, the Capital Gain (or loss) is calculated as the difference between the sale proceeds and the property's cost base. The cost base is broadly the purchase price of the property plus certain costs of acquisition, ownership and disposal — such as stamp duty, legal fees, agent commissions and capital improvement costs.
The cost base is not a fixed number. It must be reduced by certain amounts, including depreciation deductions that have been or could have been claimed. This is where the interaction with your Tax Depreciation Schedule becomes important.
How Depreciation Reduces the Cost Base
Division 43 deductions — the building write-off — directly reduce the cost base of your property. Under section 110-45 of the Income Tax Assessment Act 1997, the cost base must be reduced by the total amount of capital works deductions you have claimed (or were entitled to claim) while holding the property.
This means that even if you did not actually claim the Division 43 deduction in a given year, the ATO may still require a reduction to your cost base by the amount you could have claimed. This is a critical point — not claiming your depreciation does not protect your cost base.
An Illustrative Example
Consider an investor who purchased a residential property for $600,000 and held it for 10 years before selling for $900,000. Over the 10 years, they claimed $40,000 in Division 43 (building write-off) deductions.
Their cost base for CGT purposes would be reduced from $600,000 to $560,000 (ignoring other cost base adjustments for simplicity). The capital gain is therefore $900,000 − $560,000 = $340,000, not $300,000 as they may have expected.
However — and this is crucial — that $40,000 reduction in cost base is the same $40,000 in deductions they received over 10 years, which reduced their taxable income and income tax paid each year. In the vast majority of cases, the net tax benefit of claiming depreciation over the holding period still significantly outweighs the additional CGT payable on sale.
Plant & Equipment (Division 40) and CGT
The treatment of Division 40 (plant and equipment) items is different. These assets are depreciable assets in their own right. When a property is sold, the plant and equipment items may be:
- Sold with the property — in which case balancing adjustments may arise if the sale amount differs from the written-down value of the assets
- Retained by the seller — in which case they continue to be depreciated
For residential properties purchased after 9 May 2017 where plant and equipment was not new at purchase, the ATO restricts Division 40 depreciation to new assets only. Your tax adviser can help you navigate this correctly.
The 50% CGT Discount
If you have held the property for more than 12 months, you are generally entitled to a 50% CGT discount (for individuals). This applies to the capital gain after the cost base reduction for depreciation. The discount significantly reduces the effective tax impact of depreciation on your CGT, making the claim-or-not-claim decision straightforward in almost all cases: always claim.
What This Means for Property Investors
The key takeaways for investment property owners are:
- Depreciation deductions claimed over the years will reduce your property's cost base for CGT purposes
- Not claiming depreciation does not protect your cost base — the ATO requires a reduction for amounts you could have claimed
- In almost all circumstances, claiming depreciation produces a better financial outcome than not claiming, even after accounting for the CGT impact on sale
- Keep accurate records of all depreciation claimed, as these will be required when calculating your CGT position on sale
- Consult a registered tax agent or accountant when planning a sale — the numbers in your MTD Depreciation Schedule will be essential inputs