Source: Wealth Creator Magazine May/Jun 2006

Diminishing value method

The diminishing value method assumes that the decline in value each year is a constant proportion of the remaining value and produces a progressively smaller decline over time. The formula for working out decline in value using this method is:

Base value X Days held / 365 X 150% / Asset’s effective life

The base value is:

  • In the income year in which an asset is first used or installed ready for use for any purpose; the cost of the asset (usually the purchase price).
  • In subsequent years, the cost of the asset minus its decline in value calculated in prior year/s (also known as opening adjustable value) plus any costs incurred to bring the asset to its present condition (such as the cost of capital improvements to the asset). In any income year, the decline in value of an asset cannot amount to more than its base value.

Prime cost method

The prime cost method assumes that the value of a depreciating asset decreases uniformly over its effective life. That is, the amount of deduction remains the same each year until the asset is written off. The formula for working out decline in value using the prime cost method is:

Asset’s cost X Days held / 365 X 100% / Asset’s effective life

The prime cost formula may have to be adjusted if the cost, effective life or adjustable value of the asset is modified. Also, in any income year, the decline in value of an asset cannot amount to more than its base value.

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Appreciate depreciation

Source: Wealth Creator Magazine May/Jun 2006

Appreciate depreciation

If you invest in a residential rental property, it is important to understand what amounts you are entitled to as tax deductions for a particular income year.

Apart from those rental expenses you are entitled to as immediate deductions, such as insurance, interest and council rates. You are also entitled to a deduction for ‘decline in value’ of certain depreciating assets that form part of the rental property. For income tax purposes, ‘depreciation’ is termed ‘decline in value’.

A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. For a residential rental property, this includes items such as stoves, freestanding furniture, gas or electric heaters and washing machines.

The amount of your deduction for a depreciating asset that you hold is based in part on the time during the year in which you held the asset, used it, or had it installed ready for use, in order to produce assessable income. Also, an amount is deductible only to the extent that the property was rented or available for rental during the year of income.

Working out the deduction

You work out your deduction for the decline in value of a depreciating asset using either the prime cost method, or the diminishing value method. Both methods take into account the effective life of the asset.

The effective life of a depreciating asset is how long it can be used for a taxable purpose or for the purpose of producing exempt income: taking into account the wear and tear you reasonably expect from your circumstances of use; assuming reasonable levels of maintenance; and having regard to the period within which it is likely to be scrapped, sold for no more than scrap value, or abandoned.

No longer hold or use a depreciating asset

If you no longer hold or use a depreciating asset, a balancing adjustment event occurs. An example of a balancing adjustment event occurring is on sale of your rental property. At this time, your rental property depreciating assets would normally be sold as part of that sale.

Generally, you work out the balancing adjustment amounts for any depreciating asset by comparing the asset’s termination value (such as proceeds from the sale of the asset) and its adjustable value at the time of the balancing adjustment event. If the termination value is greater than the adjustable value for that depreciating asset, you include the excess in your assessable income. If a balancing adjustment event happens to a depreciating asset that has been used partly for a non-taxable purpose, a capital gain or loss may arise. See the Guide to Capital Gains Tax for further information about capital gain tax and depreciating assets.

Capital works deductions

Not all parts of a rental property comprise depreciating assets. The building itself, and some parts of your rental property are not deductible as depreciating assets, but a deduction is allowed for ‘capital works’. Generally, the amount of your capital works deduction is calculated by reference to the construction expenditure incurred in construction of the rental property capital works and is spread over 40 years where there is residential use.

Cost base adjustments for capital works deduction

When you sell a rental property, if you have claimed, or been entitled to claim, a capital works deduction in any year up to the year of sale, you may need to take this into account in working out any capital gain or loss on sale of the rental property.

More info:

For more information about depreciating assets in residential rental properties, visit the Tax Office website www.ato.gov.au and download the publications Rental properties (NAT 1729), Guide to Capital Gains Tax ( NAT 4151) and Guide to depreciating assets (NAT 1996).