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Understanding capital works deductions

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If you build a rental property or undertake improvements to an existing rental property which are capital in nature - replacing the roof, for instance, or installing a swimming pool - then you would normally be entitled to claim an annual tax deduction for 2.5% of the costs incurred (excluding the cost of land).

This so-called capital works deduction is a useful additional form of tax relief. It's not just available to the initial builder but also to subsequent purchasers.

The only downside is that there's a sting in the tail when you ultimately dispose of the property.

Any amounts which you have claimed as capital works deductions must be deducted from your capital gains tax cost base when you work out your capital gain on disposal.

That is to ensure that you don't get tax relief twice on the same expenditure.

Let's say that you disposed of a rental property for $700,000 in 2015, which cost $400,000 to build in 2010.

Between then and now, you have claimed $40,000 in capital works deductions.

Your cost base will be reduced by $40,000 to $360,000, giving you a gross capital gain of $340,000 ($700,000 less $360,000). That compares with a gain of $300,000 if you hadn't claimed the capital works deduction.

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Mark Chapman is director of tax communications at H&R Block, Australia's largest firm of tax accountants, and is a regular contributor to Money. Mark is the author of Life and Taxes: A Look at Life Through Tax.
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