Property Tax Depreciation – How does the commissioner determine the effective life of a depreciating asset?
I’m often asked where ‘effective lives’ come from, and the short answer is the Commissioner of taxation. The long answer is a lot more complicated than that.
For those uninitiated in how depreciation rates are calculated for plant & equipment assets, the effective life is important because it drives the depreciation rate. Take for example the addition of carpet to a rental property. As at the time of writing, the depreciation rate under the diminishing method is 20%. This is calculated by dividing 200 by an effective life of 10. The commissioner is responsible for giving us the effective life of carpet at 10 years.
Effective lives are determined by the commissioner through estimating the period if can be used by any entity for a taxable purpose (within an investment property), assuming it is:
- subject to wear and tear at a reasonable rate;
- maintained in good order and condition;
- and having regard to the period within which it is likely to be thrown away or scrapped.
The commissioner determines the effective life based on historical information and future expectations. Specifically considering things such as those mentioned below.
1. The physical life of the asset
This relates to the period a depreciating asset can be used by an entity for the relevant purpose. The case may be put that as long as the asset physically exists and is not physically exhausted, then it is able to be used. In this case we’re looking at the outer limit of an assets life through historical evidence.
2. Engineering and manufacturers specifications
The estimate of an effective life will not always remain the same. Changes in technology and the quality of manufacture will result in an increase or decline in the usable life of an asset. Manufactures specs are a good guide to how long something will last. Warranty periods can also give an indication of the evolution of an assets effective life over time. If ceiling fans that have always had a 5 year warranty, but newer models are coming out with 10 years, there’s a case to the argument for an increase in the effective life.
3. The way the asset is used by an industry
We touched previously on the past experience of users in the first point, but it’s interesting to note that not all industries use their assets in the same way. A perfect example exists in the different effective life of carpets. For example;
Residential Property = 10 years
Commercial Offices = 8 years
Accommodation Providers = 7 years
Restaurants, pubs and the like = 5 years
Perhaps the most entertaining example is the difference between the effective life of furniture in a pub depending on whether it exists in a dining area (8 years) or a drinking area (a mere 5 years!) Clearly the furniture gets a much harder time where booze is involved!
In all seriousness, this is where property owners need to engage an experienced Tax Depreciation Quantity Surveyor, as knowing the difference between these effective lives can result in significant increases in tax deductions.
4. Levels of repairs and industry standards
Some plant and equipment items could in theory be repaired on an ongoing basis in order that they continue operating indefinitely. However the legislation states that an asset only need be maintained in reasonably good order and condition. The term reasonably considers that it is not always reasonable to continue spending money on an asset where it would make more economic sense to dispose of it a purchase a new one.
5. Obsolescence, abandonment and scrapping
Plant and equipment assets can become obsolete either through technological or commercial reasons. For example, something may become commercially obsolete because the asset produces goods that are no longer required or current. Technological obsolescence is something we’re all familiar with. Anyone with a mobile phone understands that over time tools become available that perform the same tasks faster, more efficiently, and or more relevant to the greater marketplace. However an assets life does not necessarily end because something newer has come along. Obsolescence is only considered when it prevents the continued use of the asset for the purpose it was designed.
Quantity Surveyors are able to ‘scrap’ assets that have reached the point of obsolescence, or the end of their productive life. Say for example you have owned a property for some time and are undertaking renovations. Assets like old blinds, carpets, cook tops and the like will have a residual value that can be written off, as the assets are being thrown away and replaced. Scrapping is a practice that I will elaborate upon further in another article.
6. Market values, economics and financial analysis
Lease periods can be a good indicator of the effective life of an asset as it is unlikely that an asset would be leased for a period longer than it is useful. In the same way, an effective life should be no shorter than the period it can be leased for. If a company leases a crane for 10 years, they clearly believe (and have historical evidence/manufacturers specifications) that demonstrate that it will last the whole of that time. This can be expanded into a financial analysis. If for example a large manufacturing plant and equipment item costs a certain amount to purchase, there must be an expectation that it will serve its purpose preparing or producing a certain quantity of products for a certain number of years.
In evaluating market values for the determination of effective lives, it can be seen that depreciating assets with a market value will see a decline in their market value over time. For example, a brand new lawn mower might be $400 today, however in 4 years time its value will be closer to $200.
In analysing the decline in value over time, you can get a sense of the time it takes for the majority of its value to depreciate away.
In conclusion, there is a significant amount of analysis and empirical evidence that can be utilised to estimate the effective life of an asset and I hope that this explanation of some of the tools at the commissioners’ disposal sheds some light on where an effective life comes from.
It’s also important to remember that property owners are able to determine their own effective lives based on these factors, however it is best to contact a Quantity Surveyor or similarly qualified expert before doing so. I’ll be writing more on this topic at a later date.
For more information you can search for the relevant taxation legislation on effective lives, such as TR 2011/2 (as at the time of writing), where you can find more information about the determination of effective lives. This legislation is normally updated for the beginning of each financial year.
The information presented above is based on legislation prescribed by the Australian Taxation Office and the interpretation of the individual author as at the time of writing. This article should not be considered as tax advice.