As a small business owner, are you maximising potential tax deductions for your business assets?
Depreciation can provide significant savings. Consider this example: you have a piece of equipment that costs $100,000 and lasts for five years. The initial purchase isn’t an expense that you can deduct – you simply changed $100,000 worth of cash assets for $100,000 worth of equipment assets; however, by using depreciation, you can deduct that $100,000 over the five years you expect to use it for. In essence, you are using up a portion of the value of the item each year, and the Australian Tax Office (ATO) allows you to deduct that as an expense.
How do you calculate depreciation? The ATO uses two depreciation schedules:
- Prime Cost: This method deducts an identical amount each year for the useable life of the asset. In the example above, you would deduct $20,000 each year for the five-year life of the item. The formula is: Asset Cost x (Days Held/365) x (100%/Effective Life). The ‘Days Held’ component allows you to allocate a portion of depreciation to items purchased mid-financial year.
- Diminishing Value: This method allocates more depreciation at the beginning of the schedule. The formula is: Base Value x (Days Held/365) x (200%/Effective Life). Base Value replaces Asset Cost, and is recalculated each year by deducting the depreciation from the previous year’s Base Value. In the example above, the depreciation would be: Year 1, $40,000. Year 2, $24,000. Year 3, $14,400. Year 4 $8,640. Year 5, $5184. This schedule would result in the base value dropping to $7,776 by the end of year five.
Each year, your assets depreciation amounts are deducted from your assessable income (along with your other expenses) to calculate your taxable income. Which method is better? Each has its own merits. While the Diminishing Value method allows you to claim twice as much depreciation in the first year (the difference being the 200% as opposed to the 100% used in the Prime Cost formula), it is calculated on a base value that gets smaller and smaller each year. As a result, the deductions get smaller, and don’t actually reduce down to zero. So in comparison to the Prime Cost method, the Diminishing Value method will allow you to claim more initially, less later on, and you won’t be able to claim the full amount. Many businesses use the Diminishing Value method in order to maximise tax deductions early in the asset’s life, close to when the initial cost is incurred.
The example above is very simple, you need to allow for many factors in depreciation, including things like repairs that increase the value of the asset or extend its Effective Life. You also need to use an Effective Life that is realistic. For guidance on how long your asset should last, you can use the ATO’s Tax Ruling 2014/4, which has an extensive list of assets and their Effective Life. You can also pool your smaller assets into a low cost asset pool to reduce the complexity of calculations; however, to ensure your depreciation schedule is correct, it is wise to discuss your needs with a qualified tax agent.
By Jennifer Lowe
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