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.