Which Depreciation Method Should You Choose?

Which Depreciation Method Should You Choose “Depreciation Methods”

It’s important for investors to understand the effects of property depreciation and how it can change an investment, advises BMT. And with the new financial year just around the corner, now is as good a time as any.                                                     

The Australian Taxation Office allows investors to use two alternative methods of depreciation.

  • Diminishing value method – which accelerates depreciation deductions quickly.
  • Prime cost method – which spreads the deductions out over time.

According to quantity surveyors BMT, the long term intentions of the property investor will determine which depreciation method will be most suitable for them. They can only choose one though.

Each method affects the long-term cash flow position in a different way, says BMT.

“Under the diminishing value method the deduction is calculated as a percentage of the balance left to deduct. The deductions will be higher in the first five years and diminish over time. This is because a greater proportion of the asset’s cost is being claimed in the earlier years of the effective life.

“Under the prime cost method the deduction for each year is calculated as a percentage of the cost per year. This results in a more even spread of deductions over a longer time.”

The diminishing value may be an attractive option for an investor who purchases a property and wants to sell it in around five years time, because it provides higher returns over the earlier years.

However, if the owner plans to hold the property for a longer period of time, then the prime cost method might be more suitable because it provides a constant long-term projection of what the investor’s tax deductions will be.

But BMT says most investors employ the diminishing value method on both short and long term investments because depreciation deductions are cumulatively higher over the first five years of ownership, when they want or need deductions most.

An example of how the diminishing value method compares to the prime cost method in deductions obtained per year for ten years is as follows:

Year Diminishing value method Prime cost method
1 $8,658 $6,606
2 $8,930 $6,126
3 $6,948 $6,126
4 $6,197 $6,126
5 $5,103 $6,124
6 $4,408 $4,813
7 $4,118 $4,720
8 $3,744 $4,718
9 $3,513 $4,718
10 $3,368 $4,708

SOURCE: BMT; figures are based on a 15 year old house with a purchase price of $400,000.

 

Source : Australian Property Investor (June 2011)

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