Depreciate to Appreciate

The prudent approach to property investment is to consider the building upon the land merely as a vehicle to derive income from for the term of the building’s economic life. The object is to obtain the benefits of tax free capital gains on the land for as little cost to the investor as possible. Depreciation will be a much greater contributor to achieving this goal in the future than it has been in the past.

In recent years, the capital cost of investment property has sky rocketed to levels that in many cases well exceed the actual cost of the sum of its parts being the land and buildings.
When purchasing investment property, it is important to establish a long term tax strategy to deal with depreciation of the improvement. Depreciation will not apply to the land as that part of the investment will last forever and appreciate. However, the buildings, services and chattels all have very different life spans which can be depreciated at the rate of expiry of their own economic life.

In the past, buildings were generally depreciated at the rate of 2% per annum assuming a theroretic life of 50 years. However, the sum of the parts of a house all have a theroretic minimum life set by the New Zealand Building Code some as little as 10-15 years. At the building consent stage of the construction process, one has the option to reduce the life of a building to a pre selected number of years, generally the option 50 years or infinite is selected. However, you could select 10 years this would have the effect of reducing the elected economic life of a building.

It is important that at the time of purchase the value of the land and improvements is set by a valuer. Obviously a higher building value to the land value is going to assist in setting up a better depreciation schedule and a higher level of return to the investor.

Based on history and contrary to popular opinion, land values in residential and commercial property around our main cities do not grow at the same rate as the buildings upon the land. The purchase of property is generally considered the purchase of one item “property” but is actually two completely separate investments within the one package.

Land has proved to grow in value many times faster than the buildings upon the land. For example in the early 1980’s a suburban Wellington section may have cost $10,000 the house upon the land $70,000. Today the same land could cost $300,000 and the house $250,000 the land value has improved 30 times and the house itself only 4 times.

Economic limitations of the amount of rent that can be derived from tenants (without bankrupting them) in high capital investment/low interest rate times, means it will be impossible to achieve the same level of capital gains (percentage wise) in the future as have been achievable in the past 30 years.

In taking maximum advantage of a pure capital investment strategy, we are likely to see investors in the future planning to utilise property to the end of economic life, this will avoid depreciation clawback. This can be achieved in many ways, investing in potentially earthquake prone buildings without strengthening is just one example of achieving limited economic life and there are many others.

The best investment strategies for the future will include the purchase of as much land as can be purchased with an income earning building on that land close to a city. The investor that will take this approach will not be investing in unit title apartments or cross lease properties as they will ultimately want to control the land title (fee simple) to their benefit, they will not want to entrust their success to a committee decision at the back end.

Most of the investment concepts discussed in this article are of a specialist investment nature and we would encourage anyone planning to invest in this way to seek proper professional advice prior to embarking down this road.

Kate Foot is a real estate agent for Leaders