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Depreciation has slightly different meanings in personal finance, accounting and taxation. Regardless of the context, depreciation refers to the decreasing value of a good over time. It applies to cars, to home appliances and even to clothing.
Personal Finance Depreciation.
Depreciation in personal finance refers to the amount of money you lose through the decline in value of a personal asset. Assets purchased for personal reasons (not investment or business) attract no tax advantages.
The rate at which each good depreciates varies. Some items depreciate more quickly than others. The commonest example of a depreciating personal asset is your car.
In fact, cars are known to lose so much wealth through depreciation, they are often referred to liabilities. If they come with a car repayment plan, even more so.
We have all heard how a new vehicle is worthless as soon as you have driven it out of the showroom. Cars literally destroy wealth if a consumer buys too much, too new and too early.
A $30,000 car that depreciates to 70% of it’s original value over 5 years will have cost you $30,000 x70% = $21,500 over the five years.
That’s on top of fuel, insurance and registration.
Losing $21,500 every 5 years just to car depreciation is not going to help you get ahead.
There is no silver lining to depreciation in personal finance. Depreciation cannot be deducted if the item is for personal use. It is simply a fact of life that your car will be worthless and less each year until it is virtually worthless.
A key strategy to build financial security and wealth is to spend the minimum possible on vehicles until you have acquired assets that will achieve your goals in the desired timeframe.
We are more used to hearing that houses go up in value over time. But the building itself, just like cars, depreciates.
A brand new house is worth less if you try and sell it a year on than when you purchased it. Nothing has that shiny new feel to it anymore. The expected lifespan of the roof, air conditioning units, carpets and boiler has been eaten into. All these things will eventually need replacing at a cost.
What often saves your home from falling in value is the appreciation of the land it sits on. This doesn’t depreciate. There are no deteriorating parts of the land (unless you’re on a cliff!) Nothing needs replacing. Over time, as populations expand in an area that is attractive to a large number of people, the price for the land increases.
The other factor that saves your home from falling in value is any renovations and replacements you put in. Depreciation of the home is still occurring, but you are paying to replace things as they go along, helping to maintain value.
Small Goods Depreciation
Most consumer purchases you make depreciate in value significantly after purchase. If you look into selling your Nick Scali lounge second hand, even after a short period of ownership, it is unlikely you will get much of the original value back.
Some items should theoretically depreciate but don’t. Highly desirable collectables can increase in value over the years as they become more scarce. Watches, cards and pokemon cards come to mind.
To be a successful collectables investor, you need to pick collectables that will increase in scarcity and popularity over time. You are best at keeping it in its original packaging and not using it (or barely). Collectables in mint condition tend to be worth a lot more than those that have been used (and loved).
If you have an area in which you are an expert, then it is possible to succeed with collectables.
Appreciating vs Depreciating Purchases as a Predictor of Long term Wealth
There is nothing wrong with buying a depreciating asset you love. That sports car, fancy watch or brand new home are not out of bounds.
But your timing of these purchases will make or break your financial life. Given your finances dictate the options you have to choose from when life throws a curveball.
Money can allow part-time work, unpaid absences, the ability to help family members in crisis and retirement when you want or need to.
Or your finances can require you to keep working completely dependant on a monthly paycheck to pay the bills. No matter what else is going on.
The earlier in life you can money sorted, the earlier you can afford to largely ignore it.
Big financial decisions, such as the home you purchase and the cars you drive will define your future financial life.
How to Minimise the Effect of Depreciation on your Finances
Let’s start with the most powerful strategy. Home buying can create wealth, or prevent you from building any.
Is the house you will buy on appreciating land, in which case your home is an investment as well as a place to live? Be as objective in this decision as you can. What are the long term capital growth stats for the area?
If you do not buy land that is appreciating at an above-average rate, minimizing your spend on a home is a wise financial decision.
Ideally, spend more on the appreciating land than the depreciating house on it.
With cars (ignoring the rare collectable) you can avoid the sharpest dip in value from depreciation by buying a car 3-5 years old. Keep your cars as long as they are reliable.
I suspect what you may make in appreciating value or a collectible car you will likely put back into repairs and maintenance. Collectible cars seem more of a passion project than a profit-making exercise. And you definitely need to know your stuff!
Again, you shouldn’t necessarily sacrifice having that “dream car”. Especially if this is something you value. But your finances will be more supportive in the future if you can delay the purchase until you have accumulated appreciating assets.
With collectables, my impression is that many people use the idea that something is “collectable” as an excuse to buy a luxury item they can’t really afford but very much want.
Be honest with yourself, if the purchase is for your use, make sure you can afford it and accept it will depreciate with use.
Investment, Work Related and Business Depreciation.
These are all less damaging than personal finance depreciation. In fact, these depreciating purposes are likely to be necessary to earn money. They are a cost of doing business. And the good news is, they often come with a tax advantage, unlike with personal finance depreciation.
The most important concept to understand is that depreciation in your tax return is not just a tax benefit. It is partially compensating you for the loss of value that is occurring in real life.
If you purchase an asset in order to make money, you are entitled to claim the depreciation as a tax deduction. You are still losing value through real-life depreciation, but the ability to claim this on tax lessens the blow significantly.
Tax and real-life depreciation aren’t always equal.
If, for example, you had purchased a new vehicle in early 2020 for your business. Your accountant will use a method of calculating depreciation on this vehicle, and claim this depreciation against your income, lowering your tax burden. But with the vehicle shortage brought about by COVID-19, you may actually be able to sell the vehicle for more than you brought it for!
Property Tax Depreciation
The purpose of depreciation is to estimate the difference between what something is worth and how much it’s being sold for.
When purchasing an investment property, the cost of construction or renovating a property can usually be deducted over 25-40 years at 2.5-4%.
This encourages many to purchase new properties, in order to maximise the deductions. But new houses will depreciate quickly in the first few years because buying new means paying the builders margin. Remember to invest for a return first, with any tax advantages kept to an incidental bonus.
Get A Quantity Surveyor Report
When you purchase an investment property, it is important to contact a quantity surveyor and arrange a report. You need to know the costs of capital works to pass on to your accountant in order for them to claim depreciation. This costs a few hundred dollars (I paid ~$600 in Brisbane).
In an older building that hasn’t had significant renovations, there may not be enough depreciation to compensate for the cost of the report.
Capital costs of a building you purchase with a plan to demolish may be able to claim, discuss with a quantity surveyor before calling the bulldozer in!
If there is any chance you may use your current home as a rental in the future, it is important to keep records of any improvements you have made. It’s hard to predict the future, and circumstances can change quickly. Keep your records just in case.
In the event of renting the home out, talk to your accountant to find out if you can claim any of the costs you have sunk into the home.
Claiming Depreciation for Employee Work Tools
For those of us that are employees, there are limited things you can claim as a tax deduction. Equipment and books that are purchased for work for less than $300 can be claimed as an immediate deduction.
Most of you will have noticed, this is not the case with your laptop. If the item costs more than $300, it is depreciated over the accepted “effective life”. In the case of your laptop, this is two years. There are a few different methods you can use to claim this.
If you use the laptop for personal as well as work purposes, you can only claim a proportionate percentage of the cost.
Work related courses, seminars and conferences, in contrast, including travel and accommodation, can be claimed as an immediate deduction.
Working from Home Depreciation
With the rise in working from home over the past two years, you can claim office equipment, electricity and cleaning costs. You can work these out individually or use the shortcut method. Keep your bills and receipts as well as a record of your hours worked from home.
Small Business Depreciation
Depreciation of business assets is treated as a business expense that spreads the cost of a fixed asset over its useful life. Depreciation is used to account for the decline in value of an asset, and it is considered an expense. This means that depreciation expense can be deducted from revenue when calculating taxable income.
A straight line depreciation method is easy to calculate because it represents the actual loss of value. But there are also accelerated methods to reduce the accounting burden for small businesses.
Depreciation is the term used in Australia for the deduction of the cost of certain assets over their useful life. Depreciation is applied to assets that are used for business, investment or employment purposes, but can also be applied to assets used for personal reasons.
Personal assets that depreciate can cause a lot of damage to your finances. Luckily, there are some steps you can take to avoid depreciation. Buying used items or investing your earnings instead of spending as well as delaying personal spending on luxury items until you have accumulated appreciating assets will help.
Employment, investment and business depreciating assets are usually a cost of doing business, necessary to make money and attract a tax benefit.
What do YOU think? Have any other thoughts about the effects of depreciation on our lives? Let us know in the comments below!
Aussie Doc Freedom is not a financial adviser and does not offer any advice. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.