Prime cost and diminishing value are the two primary methods for calculating depreciation on assets used for income-producing purposes in Australia. This choice affects how you claim deductions on plant and equipment under Division 40 of ITAA 1997. Understanding these methods can help optimise your tax benefits.
Under the prime cost method, depreciation is calculated at a constant rate over the asset's effective life. This means you claim an equal amount each year, providing predictability in your tax deductions. For example, if an asset has a cost of $10,000 and an effective life of 10 years, you would claim $1,000 each year.
In contrast, the diminishing value method allows for larger deductions in the early years of an asset's life. Here, depreciation is calculated as a percentage of the asset's remaining value each year, leading to a higher initial deduction that decreases over time. This approach can be beneficial if you want to maximise deductions early, especially if you anticipate lower income in later years.
To see how this plays out, consider a 2015-built 3-bedroom house in Melbourne. Suppose you purchased a new hot water system for $4,000. Using the prime cost method, you would claim $400 annually over its 10-year effective life. However, with diminishing value, your first-year claim might be $600. At a 37% marginal tax rate, this increases your tax refund by $74 in the first year alone.
In our experience reviewing thousands of properties across Australia, many investors overlook the impact of choosing the right depreciation method. New investors often default to the prime cost method for its simplicity, missing out on potential early tax benefits. Additionally, some overlook how changes in income levels or business plans can affect the optimal choice between these methods.
The answer can differ depending on your situation. For instance, properties purchased after 9 May 2017 need careful consideration of plant and equipment depreciation under the 2017 budget changes. In a joint ownership scenario, the choice of method can affect each owner's tax position differently. Also, for commercial properties, the effective life of assets might differ, impacting your decision.
Choosing between these methods depends on your financial strategy, future income projections, and tax position. A Chartered Quantity Surveyor can provide detailed asset schedules, while an accountant can align these with your overall tax strategy, ensuring you choose the method that maximises your benefits.