If you own or are thinking about buying a rental property, you’ve probably heard about property depreciation. For many though, their journey stops there because they understandably perceive the depreciation process as complex and heavy on legislation. We’ve prepared this guide to property depreciation in the hopes that it will help demystify the topic and enable you to start claiming depreciation and reducing your taxable income.
What is property depreciation?
The practice of property depreciation exists to recognise that assets have an effective useful life and that there is a reasonable expectation that their value will decline over the course of this use period. This decline is recognised as a non-cash tax deduction because, though there is no monetary loss occurring, the present value of the asset will gradually decrease relative to the initial cost outlay. As such, property depreciation allows for this loss of value to be calculated, recognised, and used to offset taxable income in the years following purchase.
How to calculate depreciation on your depreciating assets
What is a depreciating asset?
Depreciating assets are those that do not form part of the rental property’s physical structure.
Per the ATO, an asset qualifies as a depreciable asset if it is:
- separately identifiable
- not likely to be permanent
- such that replacement of the item will occur within a relatively short period
- not part of the structure of the building
Examples include carpets, curtains, appliances and white goods, furniture, and floating timber flooring.
Visit the ATO’s website for more information about depreciating assets you can and can’t claim.
How to treat depreciating assets costing more than $300
Depreciation on assets costing more than $300 is recognised over the course of the asset’s effective useful life. Decisions on the length of this period can be based on either the commissioner’s determination of a particular class of asset’s effective life or your own reasonable estimation. Regardless of your decision, make sure to keep detailed records and apply figures consistently.
Having determined the effective life of your asset, there are two methods to choose from when calculating its decline in value:
- Prime cost method: this method sees depreciation recognised as a constant proportion of the asset’s initial value each year until the remaining value of the asset is zero.
Formula: Asset’s cost x (days held / 365) x (100% / asset’s effective life)
- Diminishing value method: this method sees depreciation recognised as a constant proportion of the asset’s remaining or ‘base’ value each year. As a result, higher deductions are claimed in the early years of the asset’s effective life compared to later years.
Formula: Asset’s base value x (days held / 365) x (200% / asset’s effective life)
To illustrate the difference between these methods, let’s take the example of an asset with a cost of $80,000 and an effective life of five years.
Per the prime cost method, the asset’s yearly depreciation would be:
$80,000 x (365 / 365) x (100% / 5)
= $80,000 x 20%
= $16,000 each year
In contrast, the diminishing value method will yield a different depreciation amount each year as the base value of the asset declines:
$80,000 x (365 / 365) x (200% / 5)
= $80,000 x 40%
= $32,000 in year one
($80,000 – $32,000) x (365 / 365) x (200% / 5)
= $48,000 x 40%
= $19,200 in year two
And so on…
The below graph illustrates how these two methods treat depreciation differently over the course of the asset’s effective life:
The two main points of contrast between the methods are that the diminishing value method recognises much higher levels of depreciation at the start of the asset’s life and that it also sees depreciation recorded against the asset after its effective life period is over, albeit in much smaller amounts. In comparison, the value of the asset at the end of its useful life under the prime cost method is $0.
How to treat depreciating assets costing $300 or less
Rather than being depreciated over time, an immediate full deduction can be claimed against depreciating assets costing $300 or less during the income year the asset was used for a taxable purpose.
Note that this does not apply to assets that individually cost $300 or less but are part of a set of assets costing more than $300. For example, imagine you purchase an outdoor dining setting for your rental property that includes four chairs priced at $100 each and a table costing $400. You would not be able to claim an immediate full deduction against the cost of each $100 chair because they would be considered as part of the overall setting, which cost $800 in total.
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How to calculate depreciation on your capital works
What are capital works?
The ATO defines capital works as those expenses ‘incurred in building [a] property as well as carrying out structural improvements, alterations and extensions to [a] property’. Included in this definition are preliminary expenses, such as acquiring building permits, undertaking foundation excavation, and architect, engineering and surveying fees, as well as costs pertaining to building and construction, major renovations, and adding structural improvements.
How to treat capital works deductions
Capital works deductions can be claimed against the cost of works at a rate of either 2.5% or 4% per year over the course of 40 or 25 years, respectively (the specific rate will depend on when capital works took place), as long as the property was built after 17 July 1985, is either rented or genuinely available for rent, and has had the relevant works completed. Capital works deductions cannot exceed construction expenses.
Do you have a question about property depreciation? Get in contact with us today.