Let us see the working of the two methods of calculating depreciation and understand the modalities well. In fact it is a
simple exercise.
The straight line method or the prime cost method is obviously the simpler one. Many people prefer the same as well. The calculation is very simple. In this method one has to divide 100 by the effective residual life of the asset. In case of residential property, you can take the active life of the asset as 40 years. Hence, the rate of depreciation comes to 2.5%. In the case of other assets, say carpets with an active residual life of 10 years will give you a rate of depreciation equal to 10%. The central idea behind the calculation is to ensure that the book value of the asset becomes zero after the end of the active life period.
When you use this method to calculate the depreciation, you find that the amount of depreciation remains constant throughout the entire life of the asset. Hence, if you plot a graph, you get the value of the depreciation as a straight line. Hence, it has got this popular name, the straight line method of depreciation.
The advantages of using this method are many. One advantage is that it is the simplest to calculate. Secondly, it is great for people who look to maximizing their depreciation claim in the later years. Such people could include investors who would love to stay in their own houses in the initial years before letting it out on rent subsequently. The other notable advantage is the consistency. You know that you will have this figure to claim every year thereby making your job very easier.
The diminishing value method is a slightly complex one to use. This method envisages higher deductions in the initial years subsequently tapering off by the end of the active life period of the asset. The method of calculation is slightly cumbersome. You have to divide 200 by the active residual life of the asset to arrive at the rate of depreciation. Hence, you can see that the rate of return is double that of the straight line method. In the second year you have to deduct the amount of depreciation for the first year from the value of the asset and arrive at a diminished value of the asset. You carry on this procedure until you finally exhaust the value of the asset by the end of its residual life period.
In this method, you can see that the rate of depreciation could be 5% for assets with active life period of 40 years and even 20% for assets with active life period of 10 years. However, the deductions reduce every year and hence the graph will be in a sort of a curve meeting the straight line graph at some point during the first six to eight years. Until that time you get a higher return subsequent to which your deductions will be lower than that of the straight line method.
Many business entities employ this method because it enables them to get higher returns in the initial years. The ATO allows you to claim 100% of the value if the cost of the item is less than $300.
Both these methods are very useful from the taxation point of view. The straight line method ensures that you need not have to pay a higher tax in case you experience a higher income in the subsequent years. You do not have this facility in the diminishing value method.
There is another method known as the accelerated depreciation method that allows you to speed up the depreciation to a great extent in the first couple of years. However, not all products are eligible for this benefit. You can do so for assets such as solar panels etc. In this method, you can recover the cost of the equipment early and achieve the break-even point earlier than scheduled.
These are some of the common methods of calculating tax depreciation. You have to checkup which one suits you the best before adopting the same.
Contact:
MCG Quantity Surveyors
Level 32, 1 Market Street SYDNEY, NSW
2000
Australia
taxdepreciationservices
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