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A small business owner’s guide to tax depreciation

What is Tax Depreciation? A small business owner’s guide to tax depreciation

As a small business owner, understanding what tax depreciation is and how it impacts your finances is vital to your company’s success. The Australian Taxation Office (ATO) has general depreciation rules in place that you need to follow to ensure proper accounting practices.

Below, you’ll learn everything you need to know about tax depreciation. We’ll outline what tax depreciation is and the rules the ATO has in place. By the end of this article, you’ll have a better understanding of how to handle the depreciation of your business assets.

What is tax depreciation?

Tax depreciation is a deduction that allows businesses to reduce their taxable income by claiming a portion of the cost of a depreciating asset as a tax deduction over time. This deduction is based on the decline in the value of an asset over its useful life period. 

Understanding this concept, and identifying the depreciating assets you own, will allow your business to claim a portion of the cost of eligible assets as a deduction over time. 

What is a depreciating asset?

A depreciating asset is one that declines in value over time. This includes most tangible assets with a useful life, meaning that you can estimate how long the item will remain functional. This includes assets like:

Under Australian tax law, you can claim a deduction on your taxable income for the depreciated value of assets over time.

How do you determine the depreciation value of an asset?

The ATO’s general depreciation rules set the amounts – known as capital allowances — that owners can claim based on the asset’s effective life. The ATO says that an asset’s effective life ‘is the total period it can be used by any entity for a specified purpose’. 

The organisation also clarifies that an effective life is different from the retention period, which is ‘the time a particular taxpayer expects to hold a depreciating asset for any purpose’.

These rules apply if you aren’t eligible for simplified depreciation rules. If you have an aggregated annual turnover of more than $2 million, you aren’t eligible for simplified depreciation.

The general tax depreciation rules mean you claim deductions on the depreciated worth of capital assets on your tax returns over time in one of the following two ways.

1. Prime cost

The first general tax depreciation option is called the prime cost method. In this case, the assumption is that a depreciating asset’s value declines uniformly over its effective life (i.e., depreciating by equal amounts each year).

For instance, under the prime cost method, you could have an asset worth $1,000. You estimate that its effective life is 10 years. Thus, you take $100 depreciation deductions each year, as the asset depreciates uniformly over the decade.

2. Diminishing value

The second option is known as the diminishing value method. This method calls for more graduation when you claim depreciation. It assumes that an asset’s worth drops sharply in the early years, meaning that there are higher deductions in the asset’s early life.

These deductions eventually taper off through the effective life of the product. So, take that same $1,000 asset. It may depreciate $300 after year one, $200 after year two, $100 after years three and four, and then $50 a year for years 5-10.

Comparing the prime cost method and the diminishing value method

The ATO provides a bar graph that displays a straight line for prime cost and a downward slope for diminishing value. It’s a useful tool to help see the differences between the prime cost method and the diminishing value method.

ATO’s Prime cost (straight line) and diminishing value methods graph

ATO’s Prime cost (straight line) and diminishing value methods graph

Just which method works best? It depends. The diminishing value method is generally more advantageous for small business owners for the simple reason that a dollar today is worth more than a dollar tomorrow. The prime cost method, however, offers greater consistency and if you do keep the asset for its entire useful life, this method can offer greater reductions in the long term.

As a rule of thumb, you need to be consistent with your bookkeeping methods. You cannot decide to track one asset under the prime cost method and another under the diminishing value method. Once you choose a method, you must track all of your assets this way in your accounting software. Doing so is a fundamental basic accounting practice.

How do you calculate tax depreciation?

If you’re struggling to crunch the numbers to depreciation, use the Australian Tax Offices’ capital allowances and tax depreciation calculator, which compares the results of both options.

With the capital allowances and tax depreciation calculator, you will be able to calculate the depreciation amounts for: 

  • Rental properties
  • Your small business pool
  • Your low-value pool
  • Capital works
  • Asset-based depreciation

You will also be able to calculate the share of depreciating assets in a partnership, the decline in value on multiple assets, determine balancing adjustment amounts, compare depreciation amounts between the prime cost and diminishing value methods, and save your calculations so they automatically populate future years amounts for use in your tax return, if you have a myGov account.

If you don’t have a myGov account, you can still access the calculator on this page from the ATO.

If you still need help deciding which method is best for your small business, consider consulting a trusted accountant or tax agent. These individuals can help you determine the impact of your chosen depreciation method and how the write-offs will impact your business not only this financial year but years down the road as well.

Tax depreciation for specific assets

1. How does tax depreciation impact property? 

One of the trickiest things when it comes to depreciating assets is property depreciation. If you work in real estate, own a rental property, or own an investment property for your small business, then you’re going to need to pay careful attention to what is tax-deductible through depreciation. If you have office space for your small business in some form or fashion, this likely applies to you.

Understanding property depreciation is critical because the regulations apply to not only the building itself but to everything inside it as well. For instance, the plant and manufacturing equipment, and office equipment within the building are all deductible.

By depreciating and deducting building and equipment assets, property investors can cut down on the amount of tax that they owe.

Who determines how much you can depreciate? 

If this is your first year of property ownership, you may think that you can claim amounts for your assets and come up with a tax depreciation schedule from there. However, this is not the case.

The ATO requires that you hire a quantity surveyor to determine your capital allowance and depreciation schedule. Qualified surveyors have expert knowledge when it comes to contracts and construction costs.

Finding a qualified quantity surveyor ensures your property is fully accounted for and depreciated. The surveyor will walk your building structure, determine your assessable income, and produce a tax depreciation report for you.

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Factors the quantity surveyor considers 

The quantity surveyor will primarily consider two factors when determining your depreciation rate — the capital works allowance and your plant and equipment division.

Capital works allowance 

The first thing your quantity surveyor will consider is the capital works allowance, which refers to the structural elements of a building. The capital works allowance covers all assets that are fixed and not removable. You may hear this referred to as the ‘building write-off’. This allowance does not apply to all building structures but it does cover:

  • Residential properties
  • Non-residential properties
  • Manufacturing buildings
  • Structural improvements
  • Traveller accommodations

The surveyor will determine the depreciation write-offs based on the historical cost of the building. The building write-off allowance is either 2.5% or 4% for 40 or 25 years from the construction date, based on the capital improvement works’ date of commencement. This also covers all fit-outs, extensions, and renovations.

However, the rules change when considering capital works. Different rules also apply to horticultural plants and water-supply facilities used in primary production, as well as electricity and phone connections, and assets used in mining exploration. A qualified surveyor will determine what depreciation rates your building is eligible for, for example:

Residential Property

Commercial Property

  • Windows
  • Doors, locks and door handles
  • Bathtubs
  • Swimming Pool
  • Built-in wardrobes
  • Car parks
  • Ducted air conditioning
  • Sinks and toilet bowls
  • Bricks and mortar
  • Kitchenette

Plant and equipment division 

The other main factor when determining property depreciation is plant and equipment. These are assets that tend to depreciate much more quickly than the building itself. The ATO lays out an effective life for each one of these pieces of equipment. The surveyor evaluates what you have and then lays out the schedule from there.

Note that nothing is too big or too small when it comes to depreciation. Consider some of the following items that are eligible for plant and equipment deductions:

Residential Property

Commercial Property

  • Blinds and curtains
  • Security system
  • Light fittings
  • Hot water systems
  • Smoke alarms
  • Chairs
  • Cash registers
  • Commercial ovens
  • Telephone headsets
  • Warehouse cranes and hoists

This list should demonstrate why there is a need to hire a qualified quantity surveyor. Hiring an inexperienced or unqualified surveyor could cause you to either depreciate ineligible items or, perhaps even worse, not deduct items that you’re eligible to depreciate.

2. How does tax depreciation impact mobile phones? 

As a small business owner, you or your employees may use mobile phones for work purposes, for example, to contact or manage staff. If this is the case, then you could claim your business’s mobile phones as a tax deduction. 

However, to be able to claim the decline in value of the mobile phone over its effective life, the price you paid for it must be over $300. You also need to keep in mind that only a percentage of the mobile phone and its use can be claimed if you use the device for personal and work purposes.

It is also important to keep records for the phone, data and internet, for example: 

  • Bills for your mobile plan
  • Purchase receipts for the devices you buy
  • Evidence that you do work-related phone calls from the mobile device

3. How does tax depreciation impact vehicles? 

Like property depreciation, vehicle depreciation can also be a complicated subject, and to make sure you are getting the most out of your car’s value it is essential to understand what vehicle depreciation is and how it can help your business. 

As a small business owner, there is a chance that you have a vehicle you use for work, and that it depreciates over time thanks to wear and tear. 

Depending on your eligibility, you could choose to claim business vehicle depreciation using either general depreciation or simplified depreciation rules, and in order to claim your business vehicle depreciation, you must consider the following points: 

  • The cost or original value of the car
  • The depreciation rule, or method of depreciation chosen
  • The effective life of the vehicle
  • The luxury car threshold

Once you’ve considered the above, you can determine which depreciation route is best for you and your vehicle, and move to the next steps on claiming relevant tax deductions for the depreciation of your vehicle. 

You can read our guide to business vehicle depreciation to learn more about how tax depreciation impacts vehicles.

3. Tax depreciation considerations for your small business

While depreciation is useful and can save you from having to pay more in taxes over time, you won’t recoup the full value of what you paid. Be sure to show restraint when making your next property or equipment purchase, and only do so if you know you have the cash flow to support it. You should only buy the assets you need to run your business.

Keeping in mind the 3 considerations below will help you to carry your business in a healthy manner while still getting the most out of your asset’s depreciation.

1. Depreciation occurs over time. 

You’ll never be able to deduct the full value paid for an asset when depreciating. So, no matter what you’ll pay, you won’t be able to deduct it at a 1:1 rate.

 2. You’ll only depreciate when you lodge taxes. 

So, if you make a purchase in January but don’t lodge until October, you’ll have a significant amount of time before being able to recoup any costs.

3. Tax depreciation deductions do not directly result in cash back in your pocket. 

Deductions allow you to lower your gross income and, therefore, your tax burden. For example, let’s say you have an initial gross income of $250,000 and $50,000 of your assets are eligible for depreciation. Your new gross income is $200,000.

This means that you’ll pay taxes on $200,000 in earnings instead of $250,000 in earnings. However, it doesn’t mean that you receive $50,000 back into your wallet.

If there are business assets on your wish list, make sure you have sufficient cash flow before going on a shopping spree. It might be useful to keep enough cash for a flat-screen display, coffee machine, swivel chair, or air-conditioning unit, but never buy an asset simply because it offers a tax advantage.

The bottom line about tax depreciation 

Tax depreciation can be complicated, even for savvy business owners. However, understanding depreciation can save your company money in the long run. Be sure to consult with the ATO, a qualified surveyor, and an accountant or tax agent to ensure you’re depreciating assets properly.

Lastly, remember that tax deductions are only one strategy you can take to improve your cash flow. Never stop thinking about ways to generate more capital for your business.

Frequently asked questions about tax depreciation

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