You’ve just settled on a brand new property, and you know you can take advantage of tax depreciation using one of two depreciation methods – prime cost or diminishing value.
But how does each depreciation method work? And which is better?
The best way to interpret this is to see it visually below based on an $80,000 asset:
Here’s another comparison based on a year to year dollar value change for a $50,000 asset:
Purchase Price of Asset
$50,000
Effective Life of Asset
10
Year
Prime Cost
Diminishing Value
1
$5,000.00
$10,000.00
2
$5,000.00
$8,000.00
3
$5,000.00
$6,400.00
4
$5,000.00
$5,120.00
5
$5,000.00
$4,096.00
6
$5,000.00
$3,276.80
7
$5,000.00
$2,621.44
8
$5,000.00
$2,097.15
9
$5,000.00
$1,677.72
10
$5,000.00
$1,342.18
Total Depreciation
$50,000.00
$44,631.29
As you can see, the prime cost depreciation method affords a fixed rate of depreciation. In contrast, the diminishing value method has a more significant upfront deduction in the first four years of the asset.
Before deciding which is better, you’ll need to understand how each formula is calculated:
Prime Cost Depreciation Method
The prime cost depreciation method, also known as the simplified depreciation method, calculates the decrease in value of an asset over its effective life at a fixed rate each year.
The prime cost formula is as follows:
Asset’s cost x (days held ÷ 365) x (100% ÷ asset’s effective life)
Example: Prime Cost Depreciation Method
If an asset costs $50,000 and has an effective life of 10 years, you can claim 10% of its cost in each of the ten years:
$50,000 x (365 ÷ 365) x 10% = $5,000
The depreciation calculations will continue until the final value of the asset reaches zero.
Diminishing Value Depreciation Method
The diminishing value depreciation method allows for a higher depreciation deduction in the first few years of ownership of the property.
As a result, it will decrease in depreciation deduction value each year until the asset value runs out
You can increase the claim on items valued below $1,000 using low-value pooling
For any items valued at less than $300, you can claim 100% of the value of the item immediately
The diminishing value formula is as follows:
Base value x (days held ÷ 365) x (200% ÷ asset’s effective life)
Example: Diminishing Value Depreciation Method
If an asset costs $50,000 and has an effective life of 10 years, your first year’s deduction will be:
$50,000 x (365 ÷ 365) x (200% ÷ 10) = $50,000 x 20% = $10,000
For subsequent years, the base value will reduce based on the difference between the current year and the next year. In this example, the base value for the second year of the asset will be $40,000, i.e. $50,000 minus $10,000 depreciation in value for the first year.
The second years’ deduction is calculated as:
$40,000 x (365 ÷ 365) x (200% ÷ 10) = $40,000 x 20% = $8,000
In the third year, the base value will be $32,000 and the claim will be $6,400.
In the fourth year, the base value will be $25,600, and the claim will be $5,120.
The depreciation calculations will continue until the final value of the asset reaches zero.
Brand New $400K Apartment vs Brand New $400K House
Our process has always been about being aggressive using the ‘Duo Tax Method’ – yielding a higher claimable allowance for depreciation by digging deeper into the construction make-up of a property.
The below graph represents both the diminishing value (DV) method and the prime cost (PC) method applied to each type of property we usually survey:
As you can see, apartments (black line) and their assets depreciate faster in the first few years when compared to houses as there is typically much more Plant and Equipment (Division 40) in an apartment than a house.
This is largely due to there being lower gross floor area (GFA - total floor area inside the building) and a higher ratio of fixtures and fittings in an apartment when compared to a house of similar construction cost.
After the first few years though, you can see the two lines slowly converge as plant and equipment is all depreciated. Strata plant and equipment such as lifts, gyms, pools and tennis courts are apportioned costs with values commonly eligible to be placed into the low-value pool (see below). The result is an accelerated rate of depreciation and typically higher initial deductions in the first few years.
Low-Value Pooling
When the value of your assets depreciates below $1,000, you may transfer the remaining value of the asset towards a low-value pool. Rather than making individual depreciation calculations, you’ll be able to claim deductions on depreciation for multiple assets together.
Which Depreciation Method Should I Use For My Property?
While the prime cost depreciation method provides uniform depreciation and is a more simplified method, the diminishing value depreciation method provides more upfront depreciation during the initial years before reducing over time.
There are some key factors to consider:
How long are you planning to hold onto the property? If you have no intention to sell for the next forty years (this is the effective life of a property asset), then the result for depreciation is the same. However, unforeseen circumstances do occur, and despite not planning to sell, you may have to.
Are you using the property as a principal place of residence or rental property? If you’re living in your property and then decide to rent out the property, you may lose the opportunity to claim on depreciation during the period you lived in the property. However, other factors come into play such as Government incentives and grants that may provide more significant benefits, and thus, depreciation might not be a factor.
What is your forecasted tax situation during each financial year? If you’re an investor who’s on a low income, you may be inclined to minimise your deductions in the first few years of ownership and take advantage of higher depreciation claims years down the track when you’re potentially earning a higher income.
Inflation With general prices and cost of living increasing each year due to inflation, $1 today isn’t worth $1 next year. Therefore, many investors prefer to claim the extra deductions using the diminishing value depreciation method to have the extra money to invest and use as soon as possible
This means there's no best depreciation method.
Each method has its own pros and cons with each set of depreciation rules either offers you an aggressive upfront claim or more uniform claims each year.
It’s crucial to understand that once you’ve decided on which depreciation method to use, you cannot switch.
We recommend that you make this decision with your accountant to ensure all factors are considered before determining which depreciation method is best for you.
From 12 March 2020 to 31 June 2021, the Australian government has introduced additional incentives to encourage and stimulate further spending and economic growth by allowing for accelerated depreciation deductions:
50% of the cost of an eligible asset can be claimed on depreciation once it’s been fully installed and ready for use. The remaining value must use existing prime cost or diminishing value depreciation methods
For assets that are using the prime cost depreciation method, you can claim 57.5% of the cost of the asset in its first year, if you add the asset to the small business pool.
Note – to be eligible for this, your business must be aggregating turnover below $500 million, and assets must be new depreciating assets such as plant and equipment and intangible assets.
Key Takeaways
Every investor’s situation is different. Whether you’re buying a brand new property, a second-hand property, living in it or renting it out, these circumstances all have a part to play in deciding which depreciation method to use.
Given the complexity of the situation, investors would be wise to discuss their tax matters with their accountant to ensure that they’re getting the most out of tax depreciation for their investment property.
At Duo Tax, our tax depreciation schedules provide both the prime cost and diminishing value depreciation schedules. They’re designed for both investors and accountants so that you can determine what is best for you.
Our ‘Duo Tax’ method focuses on being the most aggressive in depreciation claims, the fastest in turnaround time (within five business days) and the most affordable. To purchase your depreciation schedule, call us to get a free estimate on how much depreciation we can claim for you.
Disclaimer: Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to property investors. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal or tax advice. You should, where necessary, seek a second professional opinion for any legal or tax issues raised in your investing affairs.
Tuan Duong is an award winning Quantity Surveyor and leads Duo Tax Quantity Surveyors – Australia’s fastest growing provider of Tax Depreciation. Reach out to him directly on 0431 154 356 or email tuan@duotax.com.au
