Interest costs and fixed asset depreciation costs are two material real estate related costs that can be treated as ‘Necessary Expenses’ under the Japanese Income Tax Law (‘ITL’) article 37 and hence which are deductible for Japanese tax purposes when calculating individual real estate income. This article looks at how such tax deductible interest and depreciation are calculated and some of the special considerations that which apply.
Please also see this article for an overview of Japanese real estate taxation for individuals. Further information can be found at the following links relating to Japanese individual income tax and here relating to other real estate matters.
Interest is in deductible against real estate income if it meets the general conditions for deduction as a Necessary Expense under ITL article 37 discussed here.
However, interest paid on amounts borrowed to purchase land or rights over land (below ‘Interest Attributable to Land’) cannot be offset against other types of income but only against real estate income (Special Taxation Measures Law or ‘STML’26 no 6 (1)). In contrast, interest paid on borrowings to purchase buildings can be set off against any other class of income if there is an overall real estate loss for the year concerned.
The tax return form to report real estate income includes sections for reporting total interest costs and the amount of Interest Attributable to Land.
Given the above rule it is often necessary to allocate interest costs between interest paid to purchase land and interest paid to purchase buildings or other real estate assets.
STML 26 no 6 (2) says that when land and buildings have been purchased under a single contract and it is difficult to split the related borrowings between the amount allocable to land and the amount related to buildings or other assets then the calculation can be performed assuming that the borrowings were first used to purchase the building or other assets, with the remainder used to purchase the land.
This is generous to the taxpayer compared, for example, with an allocation of interest costs pro-rata according to the market value of the land and buildings. However, it may be necessary to obtain evidence of the value of the of the land and buildings concerned as supporting evidence for any tax deduction. This may be particularly important for property overseas where the value of the building may form a relatively higher proportion of the purchase price compared to Japan.
Example where interest paid to land is non deductible
Below is an example of a calculation of the Interest Attributable to Land showing how the limit on the set off operates. Amounts are in JPY thousands.
Assume that real estate income from a property is 11,000, total Necessary Expenses are 15,000 and the property cost 120,000, split between land of 80,000 and building of 40,000. The 120,000 purchase price was paid for by cash 20,000 and a loan of 100,000 on which 6,000 interest was paid (included in the 15,000 of Necessary Expenses). How much of the overall loss can be set off against other income of the taxpayer?
Assuming that the 100,000 loan was first applied to purchase the building then 40,000 of the loan is allocable to the building and so the remainder, 60,000, must be allocable to the land.
The amount of interest expense allocable to the land is, therefore, 6,000 interest times 60,000 of loan allocated to land divided by 100,000 total loan = 6,000 x ( 60,000/100,000) = 3,600.
Therefore of the total loss on real estate income of 11,000 income less 15,000 Necessary Expenses gives a 4,000 loss, however since 3, 600 is Interest Attributable to Land only the remaining 400 out of this 4,000 loss can be offset against income other than real estate income.
Depreciation for a building can also be deducted as a Necessary Expense from the amount of real estate income for Japanese tax purposes. The amount of the deduction depends on the useful life of the property concerned and the depreciation calculation methodology used.
The length of the useful life of a building depends on the physical construction of the property while the depreciation methodology used depends on when the building as purchased.
Note that the cost of land cannot be depreciated. Accordingly it may be necessary to evidence a split of the value of the real estate between that of the land and the building or other depreciable assets when claiming a tax deduction for depreciation.
Tax Answer 2100 (link in Japanese) gives an outline of the depreciation deduction and includes this link (in Japanese) to the list of assets for which the tax law has determined a useful life for depreciation purposes. The useful life of a building in years is used in the calculation of the amount of tax deductible depreciation each year according to one of the methodologies listed below.
Examples of useful lives
A few examples of useful lives or residential properties are given below, but proper advice from a qualified Japanese tax accountant should be obtained to confirm the amount is correctly calculated. Note that different useful lives are proscribed for buildings used as offices or for other non-residential use.
Steel frame reinforced concrete buildings or reinforced concrete buildings (鉄骨鉄筋コンクリート造又は鉄筋コンクリート造のもの) – 47 years.
Brick, stone or block construction (れんが造、石造又はブロック造のもの) 38 years.
Metal construction (thickness of internal frame exceeds 4 mm) (金属造のもの（骨格材の肉厚が四ミリメートルを超えるものに限る。）34 years.
Metal construction (thickness of internal frame exceeds 3 mm) (金属造のもの（骨格材の肉厚が三ミリメートルを超え四ミリメートル以下のもの）27 years.
Metal construction (thickness of internal frame is 3 mm or below) 金属造のもの（骨格材の肉厚が三ミリメートル以下のものに限る。）19 years.
Wood or wood composite construction 木造又は合成樹脂造のもの 22 years.
Wood frame mortar construction (木骨モルタル造のもの) 20 years.
Useful lives of second hand properties
Where a used property is purchased then, in principle, the acquisition cost of the building or other depreciable asset can be depreciated over the remaining period over which the building can be used.
However, where it is difficult to estimate the remaining useful life of such a second hand property a simplified approach can be used to depreciate its value. The simplified approach is as follows:
Where the whole of the useful life of the second hand property has already passed at the time of acquisition, the remaining useful life is 20 per cent of the useful life of the property. For example, if a wood frame mortar construction building with a useful life of 20 years is purchased more than 20 years after its original construction, the property can be depreciated with a useful life of 20 years x 20% = 4 years.
Where some part of the useful life of the building has passed at the time of acquisition then it may be depreciated over the remaining useful life plus 20 per cent of the period that has already passed. For example, a wood frame building with a useful life of 20 years purchased after 10 years have passed can be amortized over the remaining 10 years plus 20% of 10 years, in total 12 years.
There are three different methods that may apply to calculate tax deductible depreciation for a building depending on the date that it was purchased and the election of the taxpayer. These methods are:
The ‘Fixed Amount Method’ (in Japanese ‘定額法’ or ‘teigaku hou’)
The ‘Former Fixed Amount Method (in Japanese ‘旧定額法’ or ‘kyuu teigaku hou’)
The ‘Former Fixed Rate Method’ (in Japanese ‘旧定率法’ or ‘kyuu teiritsu hou’)
For buildings purchased on or after 1 April 2007 the Fixed Amount Method applies. For buildings purchased on or before 31 March 1998 then either the Former Fixed Amount Method or the Former Fixed Rate Method can be used. For other buildings (i.e. those purchased on or after 1 April 1998 but on or before 31 March 2007) then the Former Fixed Amount Method applies. Different rules apply for selecting the method for assets other than buildings but these are not discussed further here.
Depreciation under the Fixed Amount Method
The amount of tax deductible depreciation for a particular year is simply calculated as the acquisition cost of the building multiplied by the depreciation rate for the year, which is simply the reciprocal of the useful life of the building (i.e. where the expected life is ten years the depreciation factor is 1/10 =0.1).
An example of the calculation is given on the Japanese National Tax Authority (‘NTA’) website here (link in Japanese). In the example a property costing JPY1,000,000 is depreciated over its useful life of ten years. The amount of tax deductible depreciation each year is JPY1,000,000 x 1/10 = JPY100,000. Note that in the final year JPY1 cost remains so the depreciation amount is JPY99,999.
Depreciation under the Former Fixed Amount Method
The Former Fixed Amount Method differs from the above current Fixed Amount Method by specifying an assumed residual value for the property when calculating the amount of depreciation.
A tax deduction could be claimed for the cost excluding the residual value, which was typically 10 per cent of the total until the tax deduction exceeded the remaining value of the building when the remainder could be written off over later years as shown in the example.
An example is given on the home page of the NTA here (link in Japanese). The example (left column) shows a property costing JPY5,000,000 with a residual value of 10% being depreciated over five years. The annual tax deductible amount for each year is JPY5,000,000 acquisition cost less JPY500,000 residual cost = JPY4,500,000 x 1/5 for a five year life gives JPY900,000 per year. In year six this amount of JPY900,000 is greater than the residual amount so the rules allow 5% of the original acquisition cost to be depreciated, JPY250,000. The remaining balance then amortized over the five remaining years seven to eleven.
Depreciation under the Former Fixed Rate Method
This method is a “declining balance method” whereby a constant rate is applied to the remaining un-depreciated balance to find the amount of tax deductible depreciation for the year. It is used in combination with the residual value concept of the above Former Fixed Amount Method.
The rates used for this method can be found in this table – the column on the far right. The number in this column 0.369 corresponding to a five year old property is then used in the NTA example, with the depreciation for the first year being JPY5,000,000 x 0.369 = JPY1,845,000. The same rate is then used each year on the remaining balance until year seven.