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What is depreciation?

Updated: Mar 11

An asset is something you purchase for use in the business that has a useful life of more than one year and costs more than $1,000 (excluding GST). Common examples are a tractor, motorbike, ute, trailer, or silage wagon.


There can be some confusion over expenses like shed chemicals or fertiliser because these items cost more than $1,000. However, these are considered consumables or expenses because they are consumed within a year and are therefore not assets. This is where the ‘useful life of more than one year’ must be considered when trying to determine whether an expense is an asset.


If the item doesn’t meet the definition of an asset, the full cost of the item is claimed as a tax-deductible expense in the year of purchase (ie. what we call ‘expensed’). If the item is classified as an asset, then the full cost of the item is claimed as a tax-deductible expense over several years, rather than in the year of purchase (ie. what we call ‘depreciated’).


What is depreciation?


Depreciation is a method of spreading the cost of the asset over a period of several years. It is calculated based on IRD approved depreciation rates which vary for different assets depending on their useful life. For example, a tractor has a depreciation rate of 13% therefore its useful life is 15.5 years, compared to a motorbike which has a depreciation rate of 30% therefore a useful life of 6.66 years. Another example is a mobile phone which has a depreciation rate of 67% therefore a useful life of 3 years.


Depreciation is based on the fact that assets lose value over time as they get older, so is a way of being able to claim that as a tax-deductible expense. Some assets don’t have a depreciation rate as they don’t depreciate but rather appreciate, such as buildings.

The IRD has a list of all assets and their respective depreciation rates which can be accessed here: ir265-2020.pd (ird.govt.nz).


Cash timing difference


Because assets are claimed as a tax-deductible expense over a period of several years there can be a cashflow timing impact on tax. This arises because you pay for the cash value of the item up front, however the cost is not fully tax deductible in the year of purchase.


For example, you buy a tractor for $100,000 (excluding GST) at the start of the financial year. The cash is paid to the seller when you take ownership of the tractor, however only 13% ($13,000) can be claimed as tax deductible in that financial year as depreciation. This is what catches people out - they think they are reducing their tax bill by incurring a business expense of $100,000 however only $13,000 is tax deductible, therefore they still have a fair bit of tax to pay.


Depreciation is only a book entry for tax calculation purposes, and there are no cash transactions (as this already occurred when you purchased the asset).


How depreciation is calculated


Depreciation in the first year is calculated based on the depreciation rate specified by the IRD multiplied by the cost of the asset. After the first year the asset will have a book value, and in the case of the tractor above, the book value at the end of year one would be $87,000 (ie. $100,000 -  413,000).


For the second and subsequent years depreciation is calculated based on the rate multiplied by the book value. In the second year the depreciation expense is $11,310 (ie. $87,000 x 13%). This continues for each year and the amount that can be claimed as depreciation decreases as the book value of the asset decreases.


This is the most common method of depreciation used called diminishing value. There is an alternative method called straight line however this isn’t commonly used as the depreciation claimed in the first few years is lower.


Repairs vs Improving an asset


Usually repairs to an asset are tax deductible in the year incurred (ie. expensed) however any repairs that alter or improve an asset are not considered repairs and are added to the cost of the asset (ie. ‘capitalised’). For example, the tractor motor blows up and you replace it with a much more powerful motor – this is improving the tractor therefore the cost of the motor is added to the original cost of the tractor and is depreciated. If you replaced the motor with a like-for-like motor this would be considered repairs.


Depreciation recovery and loss


Another aspect of depreciation that catches some people out is depreciation recovery. This occurs when the asset is sold for more than book value. For example, in the second year you sell the tractor for $90,000 but its book value is $87,000 there is $3,000 of depreciation recovery.


Depreciation recovery means that you claimed too much depreciation in the past, because its market value is worth more than the book value, and that depreciation must be repaid. This is only a book entry for tax purposes and no cash changes hands.


Likewise, if you sell the asset for less than book value you get to claim that difference as a tax-deductible loss.


This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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