It is often said by real estate gurus that the three most important things in real estate are location, location and location. While this isn't really the whole story it does say a lot about the importance of getting the right piece of land.

A building is a depreciating asset. It loses money just like a new car loses 20% of its value the moment you drive it out of the dealer's driveway. Buildings suffer wear and tear, people want modern kitchens and bathrooms, tenants go feral, children damage things, and everyone just wants the latest design.

Only a truly gifted yobbo is capable of ruining the dirt under a house.

Land is in fairly limited supply, in particular in inner city areas and anywhere with water views. Thus when you own a piece of land in a well located area you can get good capital gains even when the building itself isn't in very good shape. Indeed frequently the highest percentage capital gains come from empty lots of land in prime locations or good land with a decaying, virtually worthless building sitting on it.

If you are entering into the real estate market to enjoy good capital gains it is therefore a good idea to limit the amount of money you pay for the building, and buy places where as much as possible of the purchase price represents the land itself.

A building is a necessary evil. Even though it depreciates and actually hurts your capital gains potential the building is what provides income. Without income you simply could not service your loan, and furthermore you wouldn't even be able to claim a tax deduction on the interest bill.

The cost of buildings depends on the cost of labour and materials which are fairly stable in real terms. As buildings deteriorate with age, the supply of accommodation will decline in the absence of new construction. As rents are set by supply and demand, when vacancies fall to the point that rental returns start to rise above a certain point this will stimulate new construction in an area, or refurbishment and renovation of older buildings.

Rents on older buildings will normally be set at a discount to newer buildings. The market value of a building will fluctuate about an equilibrium based on their cost of replacement and the increased rent that a replacement will bring.

If you want the best chance of getting good long term capital gains you should avoid the purchase of any unit where the value of the land underneath constitutes a negligible expense compared to the value of the building. In particular densely grouped dwellings and multi-storey apartment blocks, while providing good overall income yields which tend to make cash flow more manageable are not the sort of investments one would expect to provide the best capital gains.

If you buy a house on a "duplex block" in an area that is gradually being taken over by dense housing you will get an excellent capital gain, well ahead of inflation, as the median house in an area is transformed from a large block to a smaller one. When you track median house prices in such areas you frequently find that as time goes on people tend to pay as much for a high density unit as they previously did for a house on a big block.

Median house prices reflect the "normal" type of dwelling in an area. If over time the character of an area changes so that the new kind of normal becomes a smaller cottage or unit on a block half the size of previous one, the value of a larger block of land that can be split can double. On the other hand if you buy a single small unit with little splitting potential you will have to wait many years for further increases in housing density when multi-storey units may become popular.

In other words if you want a capital gain that exceeds inflation you would be best advised to seek out buildings on land with redevelopment potential, in areas that may be subject to increases in density over time.

If you do buy densely packed units you will maximise the amount of rental income that you can extract from that block of land, but your capital gains will suffer a drag from the depreciation of the building. If a building has a useful economic life of 40 years then in real terms the building will depreciate by 2.5% a year. If the building makes up 80% of the purchase price then this will mean your capital gains as a follow on will be retarded by 2% a year. The fact that you can claim this as a depreciation allowance is of small comfort, as I will explain in the next section.

Something to bear in mind about depreciation allowances

Real estate marketeers promote the depreciation allowances as wonderful tax breaks that will make you rich. At every negative gearing workshop in history the real estate guy giving the presentation has made a big deal of the allowances and painted them as a great way to minimise tax and make you rich. Depreciation allowances are nothing of the sort.

Why do you think they allow you to claim a tax deduction on curtains wearing out and the building depreciating? Because the Australian Tax Office are a bunch of really swell guys that sincerely want to give you ways to get out of paying tax?

No, you are given a depreciation allowance because in real estate you have to pay a lot of money on maintenance and replacement of worn out plant. Depreciation schedules are not worked out by jolly public servants that get up in the morning wanting to make your day a happy one. They are worked out in consultation with a variety of professionals to make a good estimate of how long things will last before you have to fork out some money to buy a new one.

So in reality the amount you can claim on depreciation is just a best guess as to how much you will need to spend on maintaining the property. If you know how tax deductions work you never get a 100% subsidy when something is tax deductible, the most you have happen is you get out of paying tax on the amount of money you claim. There is nothing fantastic about having to regularly spend money maintaining a place if all you get back is a slight discount on your taxes.

Although depreciation isn't a desirable thing, it is an inevitable thing and is virtually impossible to avoid. One might as well make the best possible use of it.

You would be mad not to carefully work out how much you can claim and claim it. The best person to see would be a quantity surveyor, he will produce an itemised table of the depreciable values of everything in the building. You then give this to a good accountant when they prepare your next tax return so all allowable deductions can be made.

Secondly there are some properties that are subject to more generous depreciation allowances than others, and some for which no allowance can be claimed at all.

Houses built before the 19th of July 1985 have no depreciation allowance on the building itself. You may be able to claim depreciation on the various fittings like carpets, curtains, electrical fittings, furniture and any improvements that have been made since 1985 of a capital upgrade type nature.

Houses built after the 19th of July 1985 may have depreciable fittings and plant just as older houses do but you can also claim a deduction on the building cost of the structure as well.

You will need to find out the original cost of the building from the builder, if the builder can not be found a reliable estimate of the cost of the building must be made (and you need to back up your figures to the ATO if they ask).

If the builder of the house can be located but refuses to tell you how much the cost of that particular building was, you can tell him that the tax act obliges him to provide this information, what usually happens is he will scurry off to his accountant and check this out and be told that indeed he must tell the investor what the original price was. If the house is not brand new, you must index your building value by deducting the appropriate amount for the age of the building.

Houses built after the 19th of July 1985 but before the 16th of September 1987 have a depreciation allowance on the structure of 4% a year, for 25 years. Once the 25 years have passed you cannot claim any further tax deductions on depreciation of the unimproved structure as it will already be fully depreciated.

Perhaps 4% a year was a bit too generous for some people's liking because after the 16th of September 1987 the depreciation schedule was amended so investors could only claim 2.5% a year over 40 years.

You cannot claim acquisition costs for a property in your income profit and loss statement, including the purchase cost of the property, finder's fees, conveyancing costs and advertising expenses. These expenses are included in the cost base of the property for capital gains tax purposes.

Borrowing expenses such establishment fees, valuation fees, title search fees and costs for preparing and filing mortgage documents, are spread over the first 5 years of the loan, or the term of the loan, whichever is lesser, unless the total cost of these is under $100 in which case they are fully deductible in the first year.

Repairs to an investment property are deductible if they relate to the repair of a damaged or worn item such as part of a fence, replacement guttering and replastering following water damage. If repairs are of a more general upgrade nature, and is likely to be seen as a home improvement such as replacing an entire old wooden picket fence with a new asbestos type, the expenditure is treated as a capital upgrade and included in capital gains calculations when you dispose of the property. Permanent improvements to the structure are regarded as capital improvements, anything from reticulation to pool pumps that are bolted to the floor, buried or otherwise considered to be installed in their permanent position is subjected to the 4/2.5% capital allowance deduction.

Travel expenses can be claimed also, if you have an interstate property and you fly to inspect the site, stay overnight and return home the next day, normally 100% of your flight and accommodation costs can be claimed as a deduction. For longer stays you may need to apportion the expenses between private holiday time and work time, unless good evidence can be provided as to why the inspection took more than one day. Other travel expenses such as travel to an investment holiday home that is rented out part of the year or time-shared must be defined as investment related or private. You are not entitled to claim the costs of flying to your investment property by the ocean if you are merely going on vacation.

So there is nothing inherently wonderful about being able to claim depreciation as a tax deduction, you certainly wouldn't call depreciation a desirable feature of real estate but it is of course something that you will have to deal with.

If you fail to spend the necessary amount of money on maintenance the house will quickly become run down and your tenants won't feel the need to look after it either.

I strongly recommend you seek your own professional taxation advice if you are going to invest in a property where you may be able to claim any deductions.