Claiming a tax deduction is usually straight forward – you simply record how much an item cost and then deduct it. But what about depreciation, which has no initial outlay and therefore no recorded cost?
In this article, we will cover:
- What is depreciation and how it’s calculated
- How to calculate depreciation for capital works
- How to calculate depreciation for plant and equipment
- Why an expert is needed
What is depreciation?
Depreciation is the natural wear and tear of property and assets over time. While everything depreciates, only owners of income-producing properties can claim it as a tax deduction.
It can be claimed on the eligible structure and fixed assets of a property (capital works), and easily removable and mechanical assets (plant and equipment). As one of the highest tax deductions available, depreciation can make a significant difference to an investor’s cash flow.
How to calculate depreciation for a rental property
Depreciation isn’t an upfront cost, in fact, it’s a ‘non-cash’ deduction as no money needs to be spent to claim it.
Therefore, more thought needs to be put into claiming it correctly. The Australian Taxation Office (ATO) has set methods of calculating depreciation and the easiest way to understand how it all works is by breaking it down via its two categories.
How to calculate depreciation for capital works
Capital works deductions are generally deducted at a fixed rate of 2.5 per cent for a forty-year period. The following calculation demonstrates how it works.
|Capital works deductions in practice: Lisa purchased a new investment property in 2020. Her property’s capital works deductions were based off a value of $380,000 which encompassed the value of the property’s structure and fixed assets.
Assuming no further capital works improvements are made, Lisa can claim $9,500 in yearly capital works deductions until 2060 (forty years)
Full year capital works deduction: $380,000 x 2.5 ÷ 100 = $9,500
How to calculate depreciation for plant and equipment
Plant and equipment depreciation deductions are calculated differently to capital works.
Firstly, each plant and equipment asset has a designated depreciable effective life that is determined by the ATO. For example, a stove holds an effective life of twelve years, while a dishwasher holds an effective life of eight years.
Secondly, there are two methods that can be used to calculate plant and equipment depreciation – prime cost, or the diminishing value method. Once a method is chosen for an asset it can’t be changed.
Prime cost method
The prime cost method, also known as the ‘straight line’ method of depreciation, calculates deductions using a uniform rate.
This rate is based off the asset’s effective life. For example, an asset with an effective life of four years will hold a prime cost method rate of depreciation of 25 per cent (100 ÷ 4 = 25). The following shows a basic demonstration of how the prime cost method works in practice.
|Prime cost method in practice: Chris purchased a digital security camera for the exterior of his rental property.
The camera’s depreciable value was $500 and it held an effective life of four years, resulting in a prime cost method depreciation rate of 25 per cent. The annual depreciation deductions would be calculated as follows.
$500 x 25 ÷ 100 = $125
Using the prime cost method, Chris can claim an annual depreciation tax deduction of $125 per year for four years on the security camera.
Diminishing value method
The diminishing value method works very differently to prime cost. Each asset has a diminishing value depreciation rate based on its effective life, which is applied to the undeducted value of a plant and equipment asset, meaning higher deductions in earlier years.
Let’s use the previous example to understand how the diminishing value method works.
Diminishing value method in practice:
Chris investigates the diminishing value method of depreciation for his security camera. Instead of 25 per cent as with the prime cost method, the diminishing value rate was 50 per cent (200 per cent ÷ 4 = 50). The yearly deductions would work as follows.
Year one deduction: $500 x 50 ÷ 100 = $250
(remaining undeducted value = $250)
Year two deduction: $250 x 50 ÷ 100 = $125
(remaining undeducted value $125)
Year three deduction: $125 x 50 ÷ 100 = $62.50
(remaining undeducted value $62.50)
Year four deduction: $62.50 x 50 ÷ 100 = $31.25
(remaining undeducted value $31.25)
Year five deduction: $31.25 x 50 ÷ 100 = $15.60
(remaining undeducted value $15.60)
Year six deduction: $15.60 x 50 ÷ 100 = $7.80
(remaining undeducted value $7.80)
Year seven deduction: $7.80 x 50 ÷ 100 = $3.90
(remaining undeducted value $3.90)
Year eight deduction: $3.90x 50 ÷ 100 = $1.95
(remaining undeducted value $1.95)
Year nine deduction = $1.95 x 50 ÷ 100 = $0.97
Why is an expert needed to calculate depreciation?
Understanding how depreciation is calculated is only scratching the surface and a tax depreciation schedule is imperative to claiming depreciation deductions effectively. There are many intricacies involved when preparing a tax depreciation schedule, including several legislative requirements to ensure that all claims are compliant.
A specialist quantity surveyor is one of the few professionals recognised as having the skills and knowledge to accurately estimate construction costs for depreciation purposes. They will prepare a comprehensive tax depreciation schedule, for your accountant to determine deductions at tax lodgement time.
To learn more about depreciation, visit BMT’s website or Request a Quote.