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Select the best method to fit your investment strategy

The Australian Taxation Office (ATO) allows investors to choose between two methods of claiming depreciation on the fixtures and fittings within their investment properties. These are the diminishing value and the prime cost methods of depreciation.

Every property investor is likely to have a different investment strategy, so it is important for them to understand how their choice between the two different methods of claiming depreciation will affect their cash flow.

The diminishing value and prime cost methods both claim the total depreciation value available over the life of a property. However, the two methods use different formulas to calculate depreciation deductions, achieving different short and long term cash flow positions for the property investor.

Legislation allows property investors who use the diminishing value method to increase the rate an asset depreciates at, therefore increasing deductions sooner. This method calculates the depreciation based upon the reduced written down value remaining so the deduction diminishes over time. The prime cost method uses a lower percentage rate of depreciation and results in a consistent deduction per year, spreading the deductions out more evenly over time.

To investigate how the outcome varies over a five, ten and fifteen year period for both methods, a sample of BMT Tax Depreciation Schedules was analysed for properties which contained assets totalling $33,000 in value.

The following plant and equipment table shows a comparison of the depreciation claimed over time, as they accumulate and in five year blocks.

Case Study

The figures in this table are based on the depreciable claim for plant and equipment only for the sample reports analysed.

The analysis found that investors who chose the diminishing value method had claimed 67% of the depreciation available in the first five years. By comparison, 42% of the depreciation available had been claimed by investors who chose the prime cost method over the same period.

At the ten year period, investors who chose the diminishing value method had claimed 91% of the deductions available, while investors who chose the prime cost method had only claimed 84% of the total deductions available.

After fifteen years investors using each method had claimed almost all the deductions available, with 98% of deductions claimed using the diminishing value method and 99% using the prime cost method. The remaining depreciation claim of $521 for the diminishing value method or $212 from the prime cost method after fifteen years would be claimed over the balance of the life of the property.

As the example shows, investors who choose the diminishing value method claim greater depreciation deductions in the earlier years of owning the property. From the sample we can see $21,991 in depreciation deductions were claimed using this method by comparison to $13,912 using the prime cost method in the first five years. If an investor is only planning on holding a property for a shorter period of time, they wish to build their investment portfolio quickly or they want to save quickly to budget for a renovation to the property, this method might be their preference.

Alternatively, those who prefer to claim deductions at a more constant rate over a longer period of time may choose the prime cost method of depreciation. As can be seen in the sample, those who chose this method would be able to claim higher deductions in the eleven to fifteen year period, where the total claim using the prime cost method was $5,026 compared with only $2,305 using the diminishing value method.

A property investor can only use one method to claim depreciation deductions. Once an investor chooses the depreciation method used for an asset, it cannot be changed. It is recommended that investors discuss which method best suits their individual situation with an Accountant and to consult with a Quantity Surveyor who will find the highest possible deductions for each of the two methods.