Here’s how depreciation works

I used to be an accountant. I know, it’s hard to fathom, but there it is. So I understand somewhat esoteric things like why assets have debit balances, even though when you have money in the bank you’re in credit, and how depreciation works, but I also understand that most people haven’t the foggiest, and many don’t want to.

Even so, let me explain how depreciation works, and how deductions for repairs work. This is, of course, of compelling interest to New Zealanders, given the recent release of the Tax Working Party’s report on how the NZ tax system could be reformed, and the pending Budget (to be delivered on Thursday this week). Seriously, if you do want to understand what the hell is going on with depreciation, then I think I’ve put a pretty good explanation together, and you may find it helpful. And then hopefully you will be in a better position to understand whatever might come out in the Budget.

In general, if you are in business (for example, running a corner shop, or a farm, or a hairdressing salon, or owning and renting out houses), then your income is whatever money (revenue) you earn from the business (sales, rent), less whatever you had to pay out (wages, stock purchases, fertilizer, shampoo, rates, I could go on forever because the list is endless). As long as you pay out the expense so that you can earn something, then you can deduct the expense (the amount you pay out) from the revenue (the money that comes in). Whatever is left over is profit, or income, and that’s what you pay tax on.

That’s pretty straight forward and easy when it comes to expenses like wages and shampoo and fertiliser. The benefit from those expenses gets used up fairly much straightaway, and you need to go out and buy some more labour (wages) or shampoo or fertiliser or whatever.

But it’s not so easy when you purchase something to use in your business that’s going to give you benefits for several years. For example, think about an office desk. Ordinarily, we would expect that a desk might last somewhere between 10 and 15 years. So the cost of that desk should be spread out over those 10 to 15 years. Call it 12.5 years. That means that each year, you should claim 8% of the cost of the desk as an expense. Let’s say the desk costs $500. 8% of 500 is $40. Each year, you should claim an expense of $40, until in the thirteenth year, you claim just the last $20, making a total expense of $500 (12 x $40 = $480, plus $20 in the thirteenth year).

That’s all that depreciation is. When you depreciate the asset, you are spreading its cost over the number of years that you expect it will be useful to you.

As you can imagine, there’s a fair amount of wriggle room in this, so the ever helpful Inland Revenue Department has published a list of the depreciation rates that business people can use: Depreciation Rates: IR265 – PDF (397kb). By the way, that “ever helpful” is not sarcastic: Inland Revenue, like its Australian equivalent, the Australian Taxation Office, is highly committed to helping business people to get their tax right.

So far so good. But what say that after 15 years or so, you’ve had enough of your old office desk, so you decide to sell it on Trade-Me (the NZ equivalent of eBay), and you get $30 for it. “Money for jam!” you think. But… not so fast, says the IRD. What the $30 shows is that you misunderestimated how long the desk would last for. So you need to write back the expenses you have claimed (depreciation) up to the level of the amount you made on sale. In effect, the $30 gets added back to your income, so the total expense you have claimed over the years is now $470 ($500 of asset expensed over 12.5 years, less the $30 you got back when you sold it).

In effect, it’s a squaring up exercise. It’s fair enough to claim the the cost of the desk as a business expense, but you have to estimate how long it will last for, and spread the cost. But estimates can be inaccurate, so when you finally get rid of the desk, you will need to do a settle up. Sometimes you will end up with a bit of income, sometimes you will end up with an expense, sometimes you will get it just right.

All that’s absolutely fine for assets which lose value, and get used up, even if it takes 10 or 20 years for that to happen. But notoriously, there are some assets which effectively last forever, and their value goes up while you hold them, and use them in your business. For example, think about buildings, or to make it even easier, think about rental houses.

Over the last 10 years or so, maybe longer, residential property prices have gone sky high, and then some. Pretty much anyone who has bought a property can expect that it will have gone up in value. So imagine that you have bought a house, for say $400,000. That house has an expected lifetime of 50 years, so you can claim an expense of $8,000 each year. You own the house for 5 years, meaning that over that time, you will have claimed $40,000 in depreciation. In theory, if the house is really being used up, it will now be worth $360,000 (that’s the cost price of $400,000, less the $40,000 depreciation you have claimed). If you sell the house, then you should get $360,000 for it. But as we all know, house prices have been going up and up, so it’s highly likely that the house you bought for $400,000 can be sold for $500,000. You have to do a bit of squaring up. Under New Zealand tax law, you are going to have to un-claim, or un-expense, all the depreciation you have claimed in the past. In other words, that $40,000 gets added back to your taxable income.

Each year when you claimed the depreciation expense, you reduced the amount of tax you have to pay. If your tax rate is 33%, then each year, you reduced your tax bill by $2,640 (that’s $8,000 of depreciation expense, times your tax rate of 33%). Now, in the year that you sell your house, you will have to pay all that deferred tax, because you are adding back all the depreciation that you have claimed. That is, you have $13,200 added back to your tax bill ($2,640 times 5). Over time, you end up paying exactly the same amount of tax as you would have paid if you hadn’t claimed the depreciation in the first place (provided that tax rates don’t change in the meantime, but that’s another story).

The big advantage of claiming depreciation on an asset that is rising in value (notoriously, residential rental properties) is that you can put off paying tax. And that gives you a financial advantage, due to the time value of money. Using a standard net present value calculation, and assuming an interest / discount rate of 5%, I reckon that in the example I have worked through, that’s worth about $1770 to you. It’s $1,770 more in your pocket, and $1,770 less in the government’s tax take. And you get that advantage because you have been able to claim a depreciation expense on an asset that in effect, isn’t being used up at all.

That’s why there might be a good case for not allowing people to claim depreciation on rental properties. Or indeed, on any buildings.

Claims for other expenses should be allowed though. It’s fair enough that people should be able to repair wear and tear, and repaint when necessary, and so on. That helps them to maintain the value of their asset. If we don’t allow them to maintain the value of their asset, then the asset really would be used up over time.

In effect, by allowing property owners to claim a depreciation expense, the government is underwriting investment in rental properties. People often buy rental properties because they think they are going to make a capital gain on them (untaxed in New Zealand). However, their cashflow becomes much easier to manage if they can put off paying tax. And that’s what depreciation (on assets that are rising in value) enables them to do. Rental property owners are able to transfer some of the risk associated with investment from themselves, to government. I would like to see that change in tomorrow’s budget. But if it does, then I think that in order to be consistent, the government will need to remove the capacity to claim depreciation on all buildings, not just rental homes. And if they do, I’m sure there will be howls of horror and outrage from the big end of town.

I’m very, very impressed if you have read all the way to the end of this post.

Disclosure: I have worked in taxation, on both the dark side and the light. I leave it to you to work out which side is which, and which I preferred, ‘though you are welcome to offer idle speculation in comments.

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22 responses to “Here’s how depreciation works

  1. Of course, if you never sell, you never have to do the squaring up.

  2. My, Deborah, you are a woman of many parts. Are you a lapsed accountant now?
    I agree with your contention that the tax advantages of owning rental properties probably need to change – no doubt they’ve played a part in the general craziness of property values. Given that home ownership is a Good Thing, but has become increasingly difficult for first-timers, I’d also really like to see some kind of scheme to help people buy their first home, like I gather exists in Australia.

  3. Raymond A Francis

    That is impressive Deborah and a good explanation
    I think I see your fathers hand here, it is good that people understand these things

  4. Deborah – do you know Raymond AF irl?

    Carol – we do have a scheme of sorts where the Govt paid up to $14 000 of the purchase price for existing homes and $21 000 for new homes (being built, to help stimulate the building market) but some have argued that simply meant that house prices went up by those amounts and did little to help people buy. We were also at a time of historically low interest rates which helped people feel able to enter the market. At the moment I think it has gone back to $7000 for first home buyers (?).

    I’m not an economist but I think the State govt slashing stamp duty on first home purchases under $600 000 is a better idea because it is a saving that can be more easily passed on to the home buyer.

    All this without the help of my father. How did I do it?

  5. Thanks Deborah for this explanation – I knew about how depreciation worked for things like computers, and office chairs, but couldn’t quite make the leap to rental housing – but have now thanks to your explanation!

    And frankly, that stinks – landlords getting a free ride courtesy of the taxpayer? NOT FAIR.

  6. I don’t know Raymond in person, but he will know who my dad is (he’s a quite distinguished primary sector accountant). NZ is a very small place… The explanation above is all my own work, but back when I was first learning bookkeeping and accountancy, Dad gave me a huge amount of help, and in recent years, we have had several entertaining evenings talking through various tax issues. And I’m not being sarcastic! So Raymond is right to pick my dad’s influence on what I have written.

  7. It’s only a free ride in the sense that houses and other buildings don’t usually lose value, so while the landlord holds the house or building, she or he gets a cashflow advantage via the tax system. If they lost value, then allowing depreciation on them would be a fair enough way of taking that loss in value into account for tax purposes.

  8. Deborah:

    I still can’t muster any sympathy for the bullshitty scaremongering over-leveraged property speculators have been indulging in over here. If you don’t leave our tax loophole alone, we’re going to hike rents and force poor people out to freeze to death in the hedgerows!

    It’s disingenuous, dishonest and I’m embarrased that the media, yet again, has basically run press releases as news rather than advertising.

  9. Are you a lapsed accountant now?

    Snort! Goes with the lapsed Catholic…

  10. We have a rental property in NSW and pay quite a bit of tax, first on the rent we get (to the federal government) and then on the land value (to the state government). As we should; it’s income and it’s wealth and we should be taxed on it. If we sold it when we’ve owned it for more than five years we would also have to pay capital gains tax. We don’t get a free ride at all, and it is part of our superannuation.

    We would be taxed a lot less if we had that money in our superannuation accounts. But we are also providing a very nice home at a reasonable cost for a family that’s not in a position to buy a house. How is that bad?

  11. I wondered if your dad was an economics professor or some such. Thank you for the straight forward explanation of depreciation.

  12. It’s not, at all.

    But as it turns out, the tax rules differ quite substantially between NZ and Australia, or they did, until this afternoon’s budget. In particular, you can’t claim depreciation on houses in Australia, whereas you can in NZ. So in NZ, you can get a substantial cashflow benefit. Plus there’s no Capital Gains Tax in NZ. So property investment had become a means for avoiding tax as much as anything else in NZ.

    That has changed somewhat in this afternoon’s budget. You will no longer be able to claim depreciation on buildings, from the tax year beginning 1 April 2011.

  13. OK; interesting, Deborah. Thanks. But I do get tired of landlord bashing. Renting houses can be a social good, I think. it is possible to do it ethically.

  14. You will like this post on Peter Martin’s blog, M-H.

    Your landlord’s not that mean

    Some months ago he linked to some article by some economist somewhere about the social benefits of housing, and pointing out that landlords can also be regarded as providing a service. I agree! Jeremy Waldron wrote an excellent piece on homelessness some years ago: Homelessness and the issue of freedom, pointing out that people who have no home literally have nowhere to be. The positive side of rental properties is that landlords provide somewhere for people to be. And provided that landlords behave ethically (charge a fair rent, pay their taxes, keep the property in good repair, treat their tenants as ends in themselves, not merely as a means to an end – I’m getting very Kantian about this), I don’t see what the problem is.

  15. Hi there!
    What an interesting article. Just wondering if you can give me some advice??
    I bought a rental property three years ago and have not claimed depreciation. I am booked into an accountant to get it done but with the new tax laws, I’m wondering if it is worth it? What do you think?
    Many thanks
    Anita

  16. It’s going to depend on your financial situation, and your intentions with respect to selling or holding on to the house. I really can’t advise you, partly because I just don’t have enough information, and partly because I’m not really in the business of giving people financial advice. But your accountant should be able to help you to work out what to do.

  17. Anita – it depends very much on which tax jurisdiction you are in.

  18. My eyes started glazing right after the first occurrence of the word “accountant”, but I did get the general gist of the post. Anyway, I’m just glad the Nats didn’t go through with the idea of taxing someone for owning their own home (capital tax or something wasn’t it?)

  19. That means you got 6 words in! Not bad at all.

    The overall point is that applying depreciation to rental houses and other buildings which are increasing in value gives owners an advantage, which is probably unfair. Remove depreciation, and you remove the (unfair) advantage.

  20. M-H:

    I’ve actually had pretty positive experiences as a tenant, and even the rough moments had more to do with dealing with human beings rather than Satanic malevolence. But I don’t make any apologies for feeling utter contempt who try to protect their tax rorts by dishonest scaremongering about people being forced out of their homes.

  21. Hi Deborah, that was a good read. I did know that you had been an accountant, so its good to finally see you explain craft. And I don’t find it boring.

  22. Thanks Deborah. That was interesting. We are ‘opportunistic’ and ’emotional’ landlords too. The house belonged to my partner and when we eventually decided to live in the same house she wasn’t quite ready to sell it, and also the market was very flat at the time. So we have it rented it for a reasonable amount. We make very little on it, with the two levels of tax, but it is part of what we consider our superannuation package; if we did sell it we would be be almost mortgage free in the house we now share – a state we’d like to attain when we retire from regular employment in about 6 years time. So we’re not really going to respond to any government changes to the taxation system or other levers – we have a cunning plan!