Claiming Depreciating Assets: A Complete Guide for Small Businesses

Before diving into the nitty-gritty of how to claim depreciating assets, let’s take a moment to define our terms. First and foremost, what are depreciating assets?

The term “depreciating assets” covers any item your business uses that loses value over time through wear and tear, age, or obsolescence. Some of the most common examples of depreciating assets 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. This is one of the most important small business tax deductions as it allows the cost of the asset to be distributed over its effective life, providing you with deductions over multiple years.

Given their power to reduce your tax bill over multiple years, it’s vital that you understand depreciating assets and correctly claim the related deductions. With this in mind, let’s cover the methods you can use to calculate depreciation.

The prime cost method for calculating depreciation

This is the simplest method, and it involves straight-line depreciation at a set rate, usually between 15% to 30% per year.

Under the prime cost method, you or your accountant will apply a fixed depreciation to the asset’s cost each year over its effective life. This results in equal depreciation deductions each year. As mentioned, typical prime cost rates range from 15% to 30% per year, depending on the type of asset.

Let’s say, for example, you purchase an asset for your business on 1 July for $10,000. If this asset has a 4-year effective life, you 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 will have been deducted through depreciation. So the asset’s recorded value would become $0. Depending on the date of purchase, the first and last year’s depreciation claims may need to be prorated as part-year claims.

Why use the prime cost method?

The prime cost method is simple to calculate and delivers consistent depreciation deductions each year. This makes it attractive to many small business owners. However, it does have its drawbacks. The prime cost method 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 when 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.


The diminishing value method for calculating depreciation

When using this method, you’ll still claim a portion of the written-down value of the asset each year. However, the deduction is higher in earlier years and declines over time. The rate usually ranges between 18.75% to 37.5%.

The diminishing value method allows you to calculate depreciation deductions in a way that reflects the typical pattern of an asset losing more value in its earlier years of use. You’ll apply a fixed percentage to the written-down value of the asset at the start of 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. It then converts to lower deductions in later years when the asset’s value has significantly declined.

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. Let’s look at that $10,000 asset again, but this time, we’ll apply the diminishing value method to calculate the depreciation rate. With a 4 year effective life and a 30% diminishing value rate, here’s what you’d be looking at claiming:

  • 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

Your total depreciation deductions using this method over 4 years would be $8,474. Note that, unlike the prime cost method, it would take more than 4 years for you to claim the full cost of the asset.

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 for calculating depreciation

The effective life method allows you to determine your own depreciation rate for tax purposes based on how long an asset is expected to be used in the business. This gives you a more tailored approach compared to the standard rates used in the other depreciation methods.

Under the effective life method, you’ll need to estimate how many years an asset will be useful for generating income. This becomes the asset’s effective life. You can then claim an equal proportion of the asset’s cost as a depreciation deduction each year over that period.

Let’s now apply this method to the $10,000 asset purchased on 1 July. If you estimate that it will have an effective life of 5 years, under the effective life method, you 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.

Why use the effective life method?

Overall, the effective life method allows you to customise your depreciation deductions within reasonable limits. It is the most flexible method for calculating depreciation, giving you the power to determine the most appropriate depreciation rate for your specific assets based on expected usage. Your reward will be a more tailored and accurate reflection of an asset’s decline in value for tax purposes.

However, you must exercise good judgment and have a reasonable basis for estimating the effective life of your assets. The ATO may scrutinise claims that differ significantly from the standard effective lives of similar assets. So if you want to avoid audits, you’ll need to ensure every asset you’re claiming is genuinely used for income-producing purposes. You’ll also have to take care when justifying the effective life and properly maintain your tax records.

Indeed, to claim depreciation using any of these methods, businesses are required to keep records showing:

  • The cost of each asset
  • When it was purchased
  • Its expected useful life.

To perfect your record-keeping capabilities, visit our guide to keeping accurate tax records.

ATO rules for depreciating assets

The ATO sets guidelines for the effective life and depreciation rates of different types of depreciating assets. These guidelines are intended 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, including 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 or 50% diminishing value depreciation rate
  • Laptop Computers and Notebooks – 2 years effective life – 50% prime cost or 100% diminishing value depreciation rate
  • Furniture – 10 years effective life – 10% prime cost rate or 15% diminishing value depreciation rate
  • Motor Vehicles – 5 years effective life – 12.5% prime cost or 25% diminishing value depreciation rate

We obviously haven’t listed the effective life rate here because businesses have the flexibility to determine their own effective lives when using this method. However, the ATO’s published rates and lives do provide a useful guide. The ATO also uses these as a benchmark to assess the reasonableness of a business’s claims.

The ATO may disallow depreciation deductions if you select an effective life that:

  1. Differs significantly from the published guidelines for similar assets
  2. Isn’t sufficiently justified

So while you do have some flexibility, following the ATO’s guidelines for effective lives and depreciation rates is a great way to ensure your depreciation claims will be accepted. The guidelines aim to provide a standardised and reasonable approach that reflects how long assets are actually used in business.

Help claiming depreciating assets

A tax agent can advise you on the most advantageous way to depreciate your business assets for tax purposes. ITP’s friendly, highly skilled tax accountants will start by gaining a thorough understanding of your situation and industry. Paired with our deep knowledge of the ATO’s guidelines, this allows us to craft a tax strategy that will deliver your best business tax return yet.

If you simply need assistance understanding what assets your small business can depreciate, ITP’s tax accountants are also more than happy to help. Phone 180 367 487 or book online today.