Lesson 4 - Depreciating Assets

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Millicent Dickerson
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1 Tax Training School Table of Contents What is depreciation and what are depreciating assets? 2 Who may claim for depreciation? 2 Calculating Depreciation 3 - Prime Cost Method 3 - The Diminishing Value Method 4 Assets held for business and personal use 5 Assets held or used for only part of the year 5 Disposal, loss or destruction of depreciating assets 6 Balancing adjustment and capital gains 8 Depreciation rate and cost limit for cars 8 Immediate deduction for assets below certain values 9 Low cost or Low Value Pool deductions 9 Substantiation 10 Page 1 of 10

2 What is depreciation and what are depreciating assets? An asset is any item, both tangible and intangible, that is able to be transformed into cash through a sale (cash itself can be considered a short-term asset). If it has a monetary value and is able to be owned and sold, it is an asset. Depreciation is the term used to describe the decline in value of assets that are held by an individual. An asset that has been purchased that costs over a certain dollar value and is expected to last for a number of years will need to have its value depreciated to recognise the fact that it will have benefits for longer than just the year in which it was purchased. Although the benefits will occur over a number of years, the value of the asset itself will gradually decline in value over that time. A deduction for the decline in value of capital assets is the way in which the cost of the asset can be spread out over a number of years. An amount is claimed each year of the item's effective life, which is a percentage of its total cost. Private or domestic expenses are never deductible. However, capital expenses can still be depreciated. Assets subject to depreciation are those which have a limited effective life and which can be reasonably expected to decline in value over time, e.g. computers, motor vehicles, tools and furniture. It does not include land, trading stock or intangible assets (unless specified separately). A deduction for the decline in value of a depreciating asset may be claimed from the time that the asset is first used for the purpose of producing assessable income. A deduction is also available for the decline in value of an asset that is installed and ready to use but is not used on a daily basis, e.g. a back-up power supply that is installed and maintained for emergency purposes. Who may claim depreciation? A decline in value may be claimed by anyone who 'holds' and uses items in producing assessable income. It is not restricted to those taxpayers with business or rental income. Often those with only salary and wages may claim for items such as tools for a carpenter. An asset may have more than one owner. In this case, the deduction needs to be calculated based on the cost of each owner's interest in the asset. A deduction for depreciation may not be claimed for assets that are being leased as they are not owned by the taxpayer. Instead, the actual lease payments are claimed. However, a hire purchase agreement implies ownership and is an exception to the rule that the taxpayer must own the depreciating item. Generally, the cost or value of the assets is that stated in the agreement. Payments are then separated into principal and interest payments. Should the hirer purchase the goods at the end of the period, they remain the owner. If the hirer does not purchase the item, then a balancing adjustment needs to be made to account for the goods being 'sold' back to the financier at market price. Taxpayers with physical disabilities are not entitled to deductions for the decline in value of medical appliances. This expenditure usually qualifies for the medical expenses rebate. Page 2 of 10

3 Calculating Depreciation Taxpayers have two methods of calculating the depreciation deduction for the decline in value of an asset. These are the Prime Cost Method and the Diminishing Value Method. The taxpayer can choose either method but once a particular method is chosen for a particular asset, that method must be used for the life of the asset. Both methods are based on the effective life of the asset and its cost. An asset MUST be depreciated if its cost exceeds $300 for an individual taxpayer or $1,000 for a business. Cost of the Asset The depreciable value of an item is its original cost plus all costs in getting the item to where it is to be used. Thus, the depreciable value of the item would include not only its purchase price or construction cost, but also items such as customs duty if it is imported, transportation in bringing it to the place where it is to be installed, in-transit insurance and the actual installation costs (first element costs). Installation costs do not include the cost of structural alterations which may be necessary or desirable for the plant's efficient integration into the working operations. Second element costs include any additions, alterations or re-erecting costs that occur after the asset has first been used and are added to the opening written down value of an asset. Effective Life The effective life is how long the taxpayer could use the asset if it is kept in good repair whilst taking account of reasonable wear and tear and the scrap value of the asset. The length of the effective life of an asset is important because it determines the rate at which the asset's value declines. Tables of the 'effective life' of assets are regularly issued by the ATO. Remember: THE DATE OF PURCHASE COUNTS AS A DAY OF OWNERSHIP! If Jane purchases an Asus EP121 on the 19th of June in a random financial year and wanted to claim depreciation for it in the next financial year, the 19th of June and the 30th of June count as days of ownership. So 19th June - 30th of June = 12 days of ownership. Prime Cost Method (PCM) The Prime Cost Method assumes that the value of a depreciating asset decreases uniformly over its effective life. In this method, a set percentage is applied to the original cost each year, i.e. instalments are claimed in equal amounts each year. The Prime Cost method is calculated as follows: Asset cost x Days held x 100% 365 Asset effective life Page 3 of 10

4 Diminishing Value Method (DVM) The Diminishing Value Method assumes that the decline in value of an asset is a constant proportion of the remaining (diminishing) value of the asset. After 10 May 2006 Base value x Days held x 200% 365 Asset effective life Note: Before 10 May 2006 the rate at which the asset was depreciated was 150% not 200%. Final note: Never round your figures to whole numbers until the very end of the equation (i.e. your final figure should be the only number to be rounded to a whole number). The new DVM rates do not apply to STS taxpayers and some certain assets. Types of assets excluded include in-house software, intellectual property assets, spectrum licenses, datacasting transmitter licences and telecommunications site access rights. The base value is calculated as: in the year of acquisition base value = asset's cost, in a later year- the base value = opening written down value (OWDV) + any additions to the cost during the year (modifications/upgrades) The opening written down value is also known as the opening adjustable value and is defined as being the value of the asset at the end of the previous year (also known as the closing written down value), i.e. the cost less its decline in value to that time. Example 1: A depreciating asset costing $10,000 acquired on the first day of Year 1 has an effective life of four years. The asset was acquired after 10 May The following table shows the annual decline in value and adjustable values under the prime cost (PC) and diminishing value (DV) methods for comparison. Prime Cost Diminishing Value Cost - 01/07/2011 $10,000 $10,000 Year 1 decline in value $2,500 $5,000 Opening written down value yr 2 $7,500 $5000 Year 2 decline in value $2,500 $2,500 Opening written down value yr 3 $5,000 $2500 Year 3 decline in value $2,500 $1,250 Opening written down value yr 4 $2,500 $1250 Year 4 decline in value $2,500 $625 Closing written down value Nil $625 Page 4 of 10

5 Under the diminishing value method, there is a balance of $625 (the written down value at the end of Year 4) which has not been written off. This amount can be further depreciated. If the asset is scrapped, the adjustable value can be claimed as a deduction. A balance less than $1,000 can be allocated to the taxpayer's low-value pool. (See page 10) Assets held for both business and personal use The decline in value of a depreciating asset is calculated from the start time, regardless of whether it is used for income-producing activities or private purposes. Where an asset has been only partly used for business (therefore taxable) purposes, the allowable deduction for the decline in value is reduced by the proportion of private use. In any situation, the non-income producing proportion of the decline in value may not be claimed as a deduction. Example 2 - A teacher purchases a computer on the 1 July 200X and uses it 40 % for private purposes and 60% for business. The cost of the computer was $2000, the effective life is 4 years and the teacher has chosen the diminishing value method. The DVM rate is 50%. What is the allowable deduction at the end of the year? Answer: $2,000 x 50% = $1,000 $1,000 x 40% = $400 Non-Deductible due to private use $1, = $600 Deductible What is the closing written down value of the computer at the end of the year? Answer: $ $1000 = $1,000 Assets held or used for only part of the year Where an asset is either held by the taxpayer for only part of the financial year or used by the taxpayer to produce assessable income for only part of the year, then the amount of the depreciation deduction must be prorated according to that proportion of the year during which it was used. Example 3: A photocopier was purchased for $10,000 on 1 January It has a useful life of 5 years. What is the allowable deduction at the end of the tax year? Use the Diminishing Value Method on the worksheet. Answer: $10,000 x 182 (days held) x 5 = $1, (days in year) 200% You will need to take leap years into account for calculations. The last leap year was 2016 and the next leap year is in Assets held for part of the year with private usage Example 4 : An asset which cost $800 has an estimated effective life of 10 years. It was purchased on the 26 th January (current year), and the owner used the asset for private use estimated at 20%. What is the decline in value that can be claimed? Use the diminishing value method on the worksheet. Assets which have been previously owned and used before becoming depreciating assets It is necessary to calculate an adjustable or written down value from the date of acquisition to the date first used. Page 5 of 10

6 Disposal, loss or destruction of depreciating assets Any asset which has been depreciated will need to have a balancing adjustment applied to it when or if the asset is destroyed, sold or lost for some reason. If the termination value on disposal is less than the adjustable value (i.e. the taxpayer makes a "loss"), a deduction is allowed for the difference; If the termination value is greater than the adjustable value (i.e. the taxpayer makes a "gain"), the difference is assessable income. Any amounts will need to be adjusted further to take into account any non-business use. The termination value is generally the amount received on disposal of the asset. This includes the market value of any non-cash business benefit. The effect of the adjustment is to ensure that the total amount allowed as a deduction (or assessable income) is equal to the actual loss (or gain) in value of the asset. Balancing Adjustment where there is no private use 1. The adjustable value of the asset at the disposal date is calculated. 2. The termination value is taken away from the adjustable amount Example 5.1 (Following Example 3 above) A) The photocopier was sold the following year on 30 th June 2016 for $5, Calculate the adjustable value at that date. Opening written down value = $10,000 $1,989 = $8,011 Depreciation for that year = $8,011 x 40% x (366 / 366) = $3, Closing written down value = $8,011 - $3, = $4, at 30 June Balancing adjustment = Sale (termination value) - closing written down value 4. Assessable Income = $5,000 - $4, = $ As the termination value is greater than the adjustable value, the result is considered as a gain. 4. Assessable income = $193 (rounded down) Example 5.2 : B) Photocopier was sold for $4,000 instead. 1. Opening written down value = $10,000 - $1,989 = $8,011 Depreciation for that year = $8,011 x 40% x (366/366) = $3, Closing written down value = $8,011 - $3, = $4, at 30 June Balancing adjustment = CWDV - termination value(sale) 2. = $4, $4,000 = $ As the termination value is less than the adjustable value, the result is considered as a loss. 1. Deductible amount = $807 (rounded up) Page 6 of 10

7 Balancing Adjustment where there has been private use The initial steps in calculating the balancing adjustment are the same as above, but the remaining balancing adjustment amount is reduced by the amount attributable to private use as follows: Total non-deductible amounts x Balancing adjustment amount Total decline in value Note : If the percentage of private use is consistent, then to calculate the assessable or deductible amounts it is a simple matter of applying that percentage to the balancing adjustment as opposed to using the above formula. Example 6 : An asset originally bought for $30,000 was sold for $19,000. Its adjusted value at that time was $19,664, and it had been used 20% of the time privately. Balancing adjustment : $19,664 $19,000 = $664 Accounting for private use: $664 x.80 = $ (deductible) The.80 shows that 80% of the use was for producing income. The remaining.20 shows the 20% of private use. Example 7 : An asset costing $30,000 on 01/07/2012 was depreciated at 22.5% (DVM), and was used partly for private purposes with private use varying from year to year. It was sold on 31/12/2015 for: (7.1) $12,000 (7.2) $25,000 Diminishing Value 22.5% Private Use % Reduction due to private use % Deduction allowed Cost $30, decline in value $6, % $2, $4, OWDV yr 2 $23, decline in value $5, % $2, $2, OWDV yr 3 $18, decline in value $4, % $1,622 $2,432 Closing value at 31/12/15 $13,965 (7.1) Sold for $12,000 on 31/12/2015 Balancing adjustment = Sell price - Closing value (If negative, it is income. If positive, it is a deduction.) = ($12,000 $13,965) = $-1,965 (a) Negative = deduction. Treat as a positive value in formula. Non-deductible amount = (Total reduction due to private use x balancing adjustment (Sell price - (a)) = ($6,938 / $13,965) x $1,965 = $ (b) Deduction allowed = (a) - (b) = $1,965 - $ = $ (7.2) Sale of $25,000 Balancing adjustment = ($25,000 - $13,965) = $11,035 (a) Page 7 of 10

8 Non-assessable amount = ($6,938 / $13,965) x $11,035 = $5, (b) Assessable income = ($11,035 $5,482.33) = $5, Balancing Adjustments and Capital Gains Although capital gains will be discussed further in the course, a mention is made here as it may arise on the disposal of a depreciating asset. If an asset is used solely for income producing activities, then no capital gain or loss arises on the disposal of the asset as a balancing adjustment occurs. If the asset was used partly for private purposes, then a capital gain or loss may arise unless it was: Acquired before 20 September 1985 A car (definition as per Item D1 deductions) A valour or bravery award given A personal-use asset (if first element < $10,000) A collectible (if first element is < $500), or, An asset in a simplified Tax system pool If the item is not excluded from capital gains then the following applies: If the termination value is less than its cost, then the remaining amount is multiplied by the non-business percentage and constitutes a capital loss If the termination value is greater than its cost, then the remaining amount is multiplied by its non-business percentage and constitutes a capital gain. Depreciation rate and cost limit for cars Under a new ruling, the effective life for cars purchased after 1 July 2002 is 8 years, with the current rate of depreciation rate set to 25% when using the Diminishing Value Method and 12.5% when using the Prime Cost Method. Cars are also subject to a limitation on the 'cost' on which depreciation is calculated. This car depreciation limit is adjusted annually for CPI and is known as the 'luxury car limit'. The car limit for the 2014/15 financial year is $57,466 (2015/16 is $57,466) with fuel efficient cars having a separate limit of $75,375 for the 2014/15 and 2015/16 financial years. If the car's cost is above the cost limit, then its value needs to be reduced down to this limit before depreciation is applied. Example 8 : A car was purchased for $70,000 in March It can only be depreciated at the limit of $57,466 - NOT the full $70,000 Car obtained at a discount If the car is obtained at a discount through the trade-in of another asset below market value (but not for any other reason), the cost of the car for depreciation may need to be adjusted. The adjustment is only necessary if the cost of the car plus the discount portion exceeds the luxury car limit and you are entitled to deduct an amount for the asset traded in. Example 9 - The car above was purchased with a discount given for a trade-in. The discount was $5,000 giving the car a price of $60,000. As the car plus the discount is above the cost limit for cars, the discount needs to be included before and then reducing it back to the cost limit before depreciation. Page 8 of 10

9 Car subject to cost limit When a car that has been subject to the car limit is disposed of, any balancing adjustment calculation is made by reference to a reduced termination value, which is determined by the following formula: Actual termination value x ( cost limit + any second element costs) Actual cost of the vehicle Example 10 - A car was purchased for $65,000 on the first day of the financial year. It was then sold at the end of the year on the 30 June for $50,000. Work out the depreciation and the reduced termination value. Depreciation Year 1 $57,466 x 25% = $14,366 Adjustable value is $57,466 - $14,366 = $43,100(CWD value) Termination value = $50,000 Reduced termination value $50,000 x $57,466 = $44,205 $65,000 Gain $44,205 $43,100 = $1,105 The gain of $1,105 needs to be added to assessable income under Item 24. The above situations would be rare for a consultant to come across and is for their general overall knowledge about depreciation. Immediate deductions for assets below certain values An immediate deduction for an asset can be claimed despite it being capital in nature. There are four tests that must be passed before an asset is considered eligible for an immediate deduction. These are: 1. The cost of the depreciating asset is less than $ You use the asset mainly for the purpose of producing assessable income that is not income from carrying on a business 3. The asset is not part of a set of assets you start to hold in the income year that costs more than $ The asset is not one of a number of identical or substantially identical assets you start to hold in the income year that together costs more than $300 Assets which are eligible for an immediate write off are not included in a low-value pool or other depreciation schedule unless the taxpayer prefers to make a claim for depreciation instead of an immediate deduction. Low-cost or low-value pool deductions Taxpayers have the option to calculate the decline in value of all depreciating items costing less than $1,000 and any existing assets already depreciated to less than $1000 under the Diminishing Value Method through a pooling scheme. The benefit of using a pooling scheme is to enable the taxpayer to access better depreciation rates (possibly). Once an item has been allocated to the pool, it is not necessary to work out its depreciation separately one annual calculation is made for all of the items in the pool. Page 9 of 10

10 Once an item has been added to the pool, it must remain there until fully depreciated. A low-cost asset is one whose total cost in its year of acquisition is less than $1,000. These assets are depreciated at 18.75% for the first year in the pool. A low-value asset is one which has an opening written down value of less than $1,000 and for which any available deductions for a decline in value have been calculated using the diminishing value method. A low-value asset is depreciated at 37.5%. Assets that may not form part of a low value pool: Assets acquired before 21 September 1999 Assets costing $300 or less (unless the taxpayer requests depreciation) Assets previously depreciated using the Prime Cost Method A separate worksheet is used for low cost or low value deductions instead of the depreciating worksheet completed for assets using either prime cost or diminishing value. Substantiation Substantiation requirements are similar to those necessary for other deductions. The taxpayer must possess evidence of the original acquisition cost of the depreciating asset. The substantiation document must specify the: Nature of the asset Date at which the asset was acquired by the taxpayer Name of the person or business name of the firm which supplied the asset Cost of the asset to the taxpayer, and; Date on which the document was filled out Common Assets Asset Effective Life Prime Cost Diminishing Value Mobile Phone 3 years 33.33% 66.67% Laptop Computer 3 Years 33.33% 66.67% Desktop Computer 4 years 25% 50% Chairs 10 years 10% 20% Desks 20 years 5% 10% Fax/Photocopy machine 5 years 20% 40% Bookcase - Metal 20 years 5% 10% - Timber 15 years 6.67% 13.33% Tools - Hand - Battery - Electric 10 years 3 years 5 years 10% 33.33% 20% 20% 66.67% 40% Page 10 of 10

1. Homework review 2. Lesson 4 Depreciation 3. Q+A

1. Homework review 2. Lesson 4 Depreciation 3. Q+A HOMEWORK Depreciation is the decline in value of an asset over time. Depreciation of certain assets can be deductible. Private or domestic expenses are