The announced budget changes by the treasurer Scott Morrison, effectively take a sledgehammer to residential depreciation legislation that hasn’t really changed since 2006. The Reserve Bank only has a blunt instrument to work with, in changing the cash rate to curb/stimulate inflation, but fiscal policy can be far more nuanced. The Government opted against a collaborative and refined methodology in favour of whacking things with a big stick.
Whilst we patiently wait for the new legislation to be drawn up, I’d like to offer up some alternatives to simply disallowing plant and equipment deductions on anything but brand-new assets.
In listening to the speech, the Government was looking to achieve two things;
- A decrease in tax deductions for property investors; and
- A way to ensure that as a property changes hands, plant assets are not repeatedly claimed, and in some circumstances, the total claims on an asset are higher than its original value.
Point two can be a difficult one to comprehend, and at first glance, it seems like the investor is claiming inappropriately. However, I’ll explain that this is part of the tax legislation.
Let’s consider a low-value object that exists in isolation. It could be a door closer, a ceiling fan, or really any plant item with an opening value (or cost if you like) of $300 or less. So, let’s say an investor buys a brand-new house, and this asset is a $180 door closer. The investor is entitled to claim the whole $180 as an instant deduction. A door closer has an effective life of 10 years, but the ATO allows these items not part of a set with a value of $300 or less to be a 100% deduction in the year of acquisition. Now, this has been the case for a long time, but where this can potentially get out of hand is when that investor sells their property to another investor. Let’s say they held the property for two years, so they’re now selling the property to an investor as a two-year-old property. Now, this door closer is, of course, two years old. Having a 10-year effective life, it’s not likely to be functioning any less like the manufacturer intended after only two years of use. It also has a value! What is the value? Well, it’s not new anymore and has had some wear, so it’s not going to be $180 anymore. Quantity Surveyors don’t appear to have a uniform means of calculating a written down value, but that’s a whole different article.
Let’s say we give the door closer the exact same value it would have had if the previous owner depreciated it under the diminishing value method based on its effective life, rather than writing it off at 100%. That would give it a value as a two-year-old door closer of $115.20.
So a Quantity Surveyor completes a depreciation schedule for investor number two and provides them with a $115.20 residual value for their door closer. Then elect to write that asset off at 100%, as they’re entitled to. See the problem now? The total deductions on that asset have now been claimed to a grand total of $195.20. We’ve now made combined depreciation claims higher than the brand-new value of the asset!
Is this investor being dodgy, sleight of hand by Quantity Surveyors? No. It’s the ATO’s rule stating you do not need to know what the previous owner claimed on the asset.
I’ll grant you that my explanation was a lengthy one, but you’ll be pleased by the brevity of my solution. Scrap 100% deductions.
I’m not in favour of this approach, but it’s a way of achieving the aims of the Government as per points 1 and 2, without completely destroying depreciation on established assets.
Investors would still be able to claim the depreciation on the door closer, but at the appropriate effective life (which the ATO give as 10 years) which equates to a depreciation rate of 20% of the balance each year under the diminishing value method, or 10% of the opening value using the prime cost method. So, it would take 10 years plus to get the whole value, rather than straight away in the first financial year, but the deductions are there nonetheless.
As for maximising Government revenue, or rather minimising tax deductions for property investors, there was a change announced to plant and equipment depreciation deductions on the 10th of May, 2006. Yes, 2006 is not a typo. Again, this was another budget night change. Nobody seems to remember this, and maybe I’m the only true tax depreciation nerd left, but on that night, the Government changed the calculation for depreciation rates for the diminishing value method.
Some background, swift as I can for those falling asleep in the back. Of the two methods of depreciation, the diminishing value method is the most aggressive in the beginning and is overtaken only by the prime cost method after around 6-7 years. For this reason, most investors use it to get their deductions sooner rather than later. The way the depreciation rates were calculated for the diminishing value method was 150 divided by the effective life. So with the door closer it would be 150/10=15%.
On that fateful 10th of May 2006 budget night, the calculation changed from 150 divided by the effective life to 200 divided by the effective life. So carpets, like the door closer, went from a depreciation rate of 15% to 20%. With most investors using the diminishing value methods, and properties changing hands relatively frequently, this resulted in higher depreciation claims and less revenue for the Government. A solution to problem 1? Put it back. Make the calculation 150/Effective life again. This would still allow investors to claim deductions on second-hand assets but would minimise the loss in tax revenue. I’m not really in favour of this change, but as per above, it would be favourable to the announced changes.
These are just two ways that the Government could have tweaked the legislation without taking a big stick to it. I’m not in favour of any changes that make things harder for investors as I believe rental accommodation is a crucial yet oft-forgotten component of housing affordability and reliance on Government pensions in retirement is far less favourable that self-funding your retirement through property investing. However, I yield to the economists far cleverer than I that say we need changes to depreciation to balance the budget, rather than tackling say, corporate tax evasion or the black economy.
These two suggestions are just what sprang to mind first, there is a myriad of other ways to achieve the implied budget aims without a blanket ban on plant and equipment deductions on established properties. If only someone would ask.