Depreciating assets are assets used by a business that lose value over time through wear and tear, age and obsolescence. Examples include equipment, machinery, vehicles, furniture and computers.
For tax purposes, businesses can claim a depreciation deduction to reflect the declining value of these assets as they are used for income producing purposes. Depreciation allows the cost of the asset to be distributed over its effective life, providing tax deductions over multiple years.
For small businesses, depreciating assets and claiming depreciation deductions can significantly reduce their taxable income and tax liability. There are a few ways depreciation can be calculated:
Prime cost method:
Straight line depreciation at a set rate, usually between 15% to 30% per year. This is the simplest method.
Under the prime cost method, a fixed depreciation rate is applied to the asset’s cost each year over its effective life. This results in equal depreciation deductions each year. Typical prime cost rates range from 15% to 30% per year, depending on the type of asset.
For example, if a business purchases an asset on 1 July for $10,000 that has a 4 year effective life, they could claim a 25% prime cost depreciation deduction each year:
- Year 1: $10,000 x 25% = $2,500 depreciation deduction
- Year 2: $10,000 x 25% = $2,500 depreciation deduction
- Year 3: $10,000 x 25% = $2,500 depreciation deduction
- Year 4: $10,000 x 25% = $2,500 depreciation deduction
After 4 years, the entire $10,000 cost of the asset has been deducted through depreciation, and the asset’s written down value is $0. Depending on the date of purchase, the first and last years depreciation claims may need to be prorated as part year claims.
The prime cost method is beneficial for businesses because it is simple to calculate and results in consistent depreciation deductions each year. However, it may not accurately reflect the actual pattern of an asset’s decline in value over time. For some assets, more value is typically lost in earlier years as the asset is newer. The diminishing value method may be a better option in those cases, as it provides higher depreciation deductions in the earlier years of an asset’s life.
Diminishing value method:
A percentage of the written down value is claimed each year. The deduction is higher in earlier years and declines over time. The rate is usually between 18.75% to 37.5%.
The diminishing value method is a way for businesses to calculate depreciation deductions for tax purposes that reflects the typical pattern of an asset losing more value in its earlier years of use.
Under the diminishing value method, a fixed percentage is applied to the written down value of the asset each year to calculate the depreciation deduction. This results in higher deductions in the earlier years when the asset is newer and loses more value, and lower deductions in later years when the asset’s value has already significantly declined.
Typical diminishing value rates range from 18.75% to 37.5%, depending on the asset type. The rate is applied to the written down value of the asset at the start of the year. The diminishing value depreciation rate is one and a half times the prime cost rate. Therefore a 25% prime cost rate would be a 37.5% diminishing value rate.
For example, if a business purchases an asset on 1 July for $10,000 with a 4 year effective life and a 30% diminishing value rate:
- Year 1: $10,000 x 37.5% = $3,750 depreciation deduction
- Year 2: ($10,000 – $3,750) x 37.5% = $2,344 depreciation deduction
- Year 3: ($10,000 – $3,750 – $2,344) x 37.5% = $1,465 depreciation deduction
- Year 4: ($10,000 – $3,750 – $2,344 – $1,465) x 37.5% = $915 depreciation deduction
Total depreciation deductions under this method over 4 years is $8,474. It will take over 4 years to claim the full costs unlike the prime cost method.
The diminishing value method more closely aligns with the typical pattern of an asset’s value decline. Assets tend to lose more value in their earlier years as they are newer, so this method provides larger depreciation deductions upfront to match that reality.
The effective life method allows businesses to determine their own depreciation rate for tax purposes based on how long an asset is expected to be used in the business. This provides a more tailored approach compared to the standard rates used in other depreciation methods.
Under the effective life method, the business estimates how many years an asset will remain in use and be useful for generating income. This becomes the asset’s effective life. The business then claims an equal proportion of the asset’s cost as a depreciation deduction each year over that period.
For example, if a business purchases an asset on 1 July for $10,000 and estimates an effective life of 5 years, under the prime cost method they would claim a 20% depreciation deduction each year:
- Year 1: $10,000 x 20% = $2,000 depreciation deduction
- Year 2: $10,000 x 20% = $2,000 depreciation deduction
- Year 3: $10,000 x 20% = $2,000 depreciation deduction
- Year 4: $10,000 x 20% = $2,000 depreciation deduction
- Year 5: $10,000 x 20% = $2,000 depreciation deduction
Total depreciation deductions again equal the $10,000 cost of the asset over its 5 year effective life.
The effective life method provides businesses with flexibility to determine the most appropriate depreciation rate for their specific assets based on expected usage. This can result in a more tailored and accurate reflection of an asset’s decline in value for tax purposes.
However, businesses need to exercise good judgment and have a reasonable basis for estimating the effective life of their assets. The ATO may scrutinize claims that differ significantly from the standard effective lives of similar assets.
Overall, the effective life method allows businesses to customize their depreciation deductions within reasonable limits. But care must be taken to justify the effective life chosen for each asset and properly maintain records.
To claim depreciation, businesses must keep records showing the cost of each asset, when it was purchased and its expected useful life. Assets must also be used for income producing purposes to be eligible.
The ATO sets guidelines for the effective life and depreciation rates of different types of depreciating assets to assist businesses in calculating their depreciation deductions for tax purposes.
The ATO publishes tables listing the effective lives and depreciation rates for various asset classes like plant and equipment, furniture, vehicles, and computers. These are based on the ATO’s estimates of how long similar assets are typically used in business.
For example, the ATO’s table lists:
- Desktop Computers – 4 years effective life, 25% prime cost/ 50% diminishing value depreciation rate
- Laptop Computers/notebooks – 2 years effective life, 50% prime cost/100% diminishing value depreciation rate
- Furniture – 10 years effective life, 10% prime cost rate/15% diminishing value depreciation rate
- Motor Vehicles – 5 years effective life, 12.5% prime cost/25% diminishing value depreciation rate
While businesses have some flexibility to determine their own effective lives for assets under the effective life method, the ATO’s published rates and lives provide a useful guide. The ATO also uses these as a benchmark to assess the reasonableness of businesses’ own claims.
The ATO may scrutinize and potentially disallow depreciation deductions where a business has determined an effective life that differs significantly from the ATO’s published guidelines for similar assets, without sufficient justification.
So while businesses do have some flexibility, following the ATO’s guidelines for effective lives and depreciation rates for different asset classes helps to ensure depreciation claims will be accepted. The guidelines aim to provide a standardized and reasonable approach that reflects how long assets are actually used in business.
A tax agent can advise you on the most advantageous way to depreciate your business assets for tax purposes, based on a thorough understanding of your situation and industry as well as the ATO’s guidelines. If you need help understanding how and what your small business can depreciate an ITP tax Accountant will help. Phone 180 367 487 or book online today.