IN THIS ARTICLE
- What is Tax Depreciation?
- How to Determine an Asset’s Depreciation Value – General Rules
- Simplified Depreciation Rules for Small Businesses
- Temporary Full Expensing
- Capital Works Deductions
- Deductions for Other Capital Assets and Expenses
What is Tax Depreciation?
Tax depreciation is the decline in value of a depreciating asset over time, for tax purposes. Assets, such as buildings, equipment, and vehicles, deteriorate or become obsolete over their useful lives. This decline in value can be claimed as a tax deduction against assessable income, thereby reducing taxable income.
A depreciating asset refers to an asset that is anticipated to have a finite useful life and is projected to lose value gradually as time passes. These assets are used in the production of income or to carry on a business. Depreciating assets can include tangible assets like buildings, machinery, furniture, and vehicles and intangible assets like patents, copyrights, and software.
How to Determine an Asset’s Depreciation Value – General Rules
To calculate your depreciation deduction for most assets, you need to apply the general depreciation rules. However, different rules may apply if you qualify for instant asset write-off or simplified depreciation for small businesses.
The general depreciation rules determine the capital allowances you can claim on your tax return based on the asset’s effective life.
What is the Effective Life of an Asset?
An asset’s effective life refers to the entire duration any entity can utilize for a specific purpose. It represents the total lifespan of the asset as determined by its functionality and usage.
It’s important to note that the effective life of an asset should not be confused with its retention period. The retention period is the length of time a specific taxpayer intends to retain or hold a depreciating asset for any purpose. In contrast, the effective life focuses on the broader concept of how long the asset can be effectively used by any entity, irrespective of individual ownership or intentions.
Choosing a Depreciation Method
You can calculate depreciation by applying any of the following two methods:
- the prime cost method
- the diminishing value method
In some cases, you may be required to use the same method as the previous asset owner, such as when acquiring it from a spouse or business partner. Nevertheless, specific intangible depreciating assets, such as intellectual property, are exclusively subject to depreciation calculations utilizing the prime cost method.
Whatever method you choose to calculate depreciation, you have to determine the asset’s effective life.
1. Prime Cost (Straight-Line) Method
The prime cost method is one of the two primary methods used to calculate depreciation. This method (also called the straight-line method) allocates an equal amount of depreciation expense to each year of the asset’s effective life. The method assumes a linear decline in the asset’s value over time, resulting in a consistent depreciation deduction each year.
The formula is as follows:
Asset’s cost × (days held ÷ 365) × (100% ÷ asset’s effective life)
An important point to note here is that the term “days held” refers to the duration you possessed the asset during the specific income year in which you utilized it or had it installed and prepared for use. In the case of a leap year, where an additional day is present, the days held can extend up to 366.
Example 1: Prime Cost Method
If an asset costs $60,000 (excluding GST if applicable) and has an effective life of five years, you can claim 20% of its cost, which is $12,000, in each of the five years.
The calculation is:
$60,000 × (365 ÷ 365) × (100% ÷5) = $12,000
This calculation includes the amount paid for the asset as well as any additional expenses for transport, installation, or making it ready for use.
Remember, if you bought the asset in the middle of the year, the calculation for depreciation using the prime cost method will be a little different. In this case, you’ll need to make the final calculation in the sixth year to include the portion of depreciation that wasn’t claimed in the first year.
2. Diminishing Value Method
The diminishing value method is another commonly used approach for depreciation calculations. It recognizes that assets tend to lose value more rapidly in the early years of their effective life. Under this method, a higher percentage of the asset’s value is claimed as depreciation in the initial years, with the depreciation amount gradually decreasing over time.
You can use the following formula for this method:
Base value × (days held ÷ 365) × (200% ÷ asset’s effective life)
Note: In a leap year, the days held can be 366.
Example 2: Diminishing Value Method
This table represents the diminishing value method for an asset that costs $80,000 with a five-year effective life. The calculations for the depreciation claim are based on a 40% depreciation rate.
|Year||Asset Value||Decline in Value||Depreciation Calculation||Depreciation Claim|
|1||$80,000||–||$80,000 × (365 ÷ 365) × (200% ÷ 5) = $80,000 × 40% = $32,000||$32,000|
|2||$48,000||$32,000||$48,000 × (365 ÷ 365) × (200% ÷ 5) = $48,000 × 40% = $19,200||$19,200|
|3||$28,800||$19,200||$28,800 × (365 ÷ 365) × (200% ÷ 5) = $28,800 × 40% = $11,520||$11,520|
|4||$17,280||$11,520||$17,280 × (365 ÷ 365) × (200% ÷ 5) = $17,280 × 40% = $6,912||$6,912|
|5||$10,368||$6,9122||$10,368 × (365 ÷ 365) × (200% ÷ 5) = $10,368 × 40% = $4,147||$4,147|
Similar to the prime cost method, this calculation includes the asset’s cost and any additional expenses.
The base value of the asset reduces each year by the decline in its value. This pattern continues until the asset’s value reaches zero.
If the asset was acquired before 10 May 2006, the formula for the diminishing value method is slightly different:
Base value × (days held ÷ 365) × (150% ÷ asset’s effective life)
Thus, we can say that it is important to determine the effective life of an asset and choose the appropriate depreciation method. The prime cost method assumes a uniform decrease in value over time, while the diminishing value method accounts for a more rapid decline in the early years.
To calculate depreciation for most assets in a particular income year, you can use the Depreciation and capital allowances tool, which compares the results of both methods and provides disposal outcomes.
Which Method is the Best?
Determining which depreciation method is preferable depends on individual circumstances. Typically, small business owners find the diminishing value method more beneficial because money holds greater value today than in the future. This approach allows for larger deductions during the initial years of asset ownership.
On the contrary, the prime cost method offers consistency in depreciation calculations. If you plan to utilize the asset throughout its entire useful life, this method can result in greater overall reductions over an extended period.
Consistency is key when it comes to bookkeeping practices. Once you select a depreciation method, applying it uniformly to all your assets within your accounting software is crucial. This adherence to a specific method is considered a fundamental principle in the field of accounting.
Reduction for Non Taxable Use
When it comes to the decline in value of a depreciating asset, regardless of the chosen depreciation method, a deduction is subject to reduction based on the extent of its non-taxable usage. This means that if an asset is used for non-taxable purposes, such as personal use, the deduction for its decline in value is adjusted accordingly.
For instance, when an asset is utilized for private purposes 30% of the time, the deduction for its decrease in value would be diminished by 30%.
As a result, all the previously mentioned figures would be multiplied by a factor of 0.6 to account for the non-taxable usage.
Transfer to Low Value Pool
Once the value of an asset falls below $1,000, there is an option to transfer the remaining value to a low-value pool. This allows for consolidating depreciation calculations for low-value assets instead of calculating them separately.
By transferring the remaining value to a low-value pool, you can claim depreciation for the asset and any other low-value assets. This simplifies the depreciation process by streamlining the calculations and treatment of these assets.
Simplified Depreciation Rules for Small Businesses
Simplified depreciation rules offer small businesses with an aggregated turnover below specific thresholds a streamlined approach to managing their depreciation deductions. Businesses meeting the eligibility criteria can benefit from the instant asset write-off and small business pool, making the process more efficient and accessible.
Eligible entities for simplified depreciation include sole traders, partnerships, trusts and corporate entities that are carrying on a business and have an aggregated annual turnover of less than $10 million. This means that entities deriving passive income in the form of rents will not be eligible and will need to use the Division 40 depreciation rules instead.
Aggregated annual turnover is the annual turnover of the business plus the annual turnover of entities that are connected with or affiliated with the business. “Connected with” and ‘affiliated’ are defined terms that are also relevant for working out whether a company is a base rate entity (and therefore eligible for the 25% corporate rate).
Instant Asset Write Off
The instant asset write off (IAWO) allows eligible businesses to immediately deduct the cost of assets that fall below the relevant threshold. This deduction can be claimed in the year the asset is first used or installed for business purposes. It provides businesses with the advantage of accelerating deductions and allows them to invest in assets more effectively.
However, it’s important to note that from 7.30pm AEDT on 6 October 2020 to 30 June 2022, the instant asset write off threshold does not apply to businesses using the simplified depreciation rules. These businesses must deduct the business portion of the asset’s cost under temporary full expensing.
For assets acquired from 1 July 2023 to 30 June 2024, the IAWO limit will be $20,000. Whether the IAWO limit reverts back to $1,000 per asset from 1 July 2024 remains to be seen.
Small Business Pool
The small business pool simplifies the calculation of depreciation deductions for higher-cost assets. For income years ending between 6 October 2020 and 30 June 2023, the balance of the small business pool must be deducted under temporary full expensing at the end of the income year.
For income years ending before 6 October 2020, businesses can pool the business portion of higher-cost assets and claim a 15% deduction in the year the assets are first used or installed. From the second year onwards, a 30% deduction can be claimed. If the pool balance is less than the instant asset write-off threshold at the end of the income year, the remaining pool balance is deducted.
Applying Simplified Depreciation
Only the business portion of the cost of depreciating assets acquired can be added to the GLVP or deducted in full under the IAWO rules. The car limit applies to the cost of passenger vehicles.
Where assets in the GLVP are disposed of, the proceeds from the disposal (including any insurance proceeds) are subtracted from the pool balance. Where assets such as cars are traded in and there is a net amount payable there are really two transactions – the disposal of one asset and the acquisition of another. The tax depreciation treatment should reflect the gross amounts rather than the acquisition of a new asset for the net amount.
The GLVP opening balance for small business taxpayers using simplified depreciation as at 1 July 2023 will be zero (because of the operation of the TFE rules). Depreciating assets costing more than $20,000 are added to the pool and attract a 15% deduction in the year ending 30 June 2024. Once in the pool, individual assets are not separately depreciated. Instead, the entire closing balance as at 30 June 2024, which becomes the opening pool balance as at 1 July 2024, will be depreciated at 30%in the 2024/25 income year.
Another important aspect to consider is that passenger vehicles have specific car cost limits, and certain assets are excluded from these rules.
Ceasing Simplified Depreciation
If you choose to stop using simplified depreciation or become ineligible, alternative methods are available for calculating depreciation deductions. Assets purchased from 7.30pm AEDT on 6 October 2020 to 30 June 2023 can be deducted using temporary full expensing. Alternatively, you can opt for the backing business investment – accelerated depreciation rules or the general depreciation rules.
You can continue claiming a 30% deduction for your small business pool assets until the balance falls below the instant asset write-off threshold. After that, you can deduct the remaining pool balance.
It is important to note that you cannot add new assets to the pool or claim instant asset write-offs under these circumstances. The balance of your small business pool must be deducted at the end of an income year between 6 October 2020 and 30 June 2023.
An entity using simplified depreciation can choose to revert to the ‘normal’ Division 40 depreciation rules in a later income year. The entity should simply lodge their next return on the new basis and retain their records for five years. There is no requirement to formally notify the ATO of their choice.
In an income year when a taxpayer chooses to stop using simplified depreciation or ceases to be eligible (their turnover might exceed $10 million), they must stop claiming IAWO deductions and stop adding the business cost of newly acquired depreciating assets to the GLVP. The normal Division 40 depreciation rules will apply to their newly acquired depreciating assets. As for the closing balance of their GLVP, the law does not require them to unscramble the egg and the pool balance will continue to be written off at 30% until it falls below the $20,000 threshold, when the remaining pool balance is deducted in full.
Entities choosing to stop using simplified depreciation after 30 June 2023 will be prevented from re-entering the simplified depreciation rules for a period of five years after opting out.
Reusing Simplified Depreciation Rules
If you decide to resume using the simplified depreciation rules, you need to adjust the opening pool balance for any depreciating assets that you have used or installed since you last used these rules. To calculate the new opening pool balance, you should add the previous closing balance to the business portion of the value of assets that were not previously added to the pool.
We are aware of some small businesses opting out of simplified depreciation early in the TFE regime because of concerns that the large deductions generated under the TFE incentive were being wasted. This was particularly noticeable in non-corporate entities that were unable to benefit from the temporary loss carry-back rules. Some trusts were at risk of wasting franking credits and individuals risked wasting their tax-free thresholds.
Reverting back to Division 40 depreciation enabled those taxpayers to opt out of TFE on an asset-by-asset basis and avoid the tax detriment that might have otherwise resulted from the immediate tax write-off of high-cost depreciating assets. Why simplified depreciation taxpayers were hung out to dry in this way has never been satisfactorily explained. But it is what it is, and the work-around by opting out was available where it was needed.
A number of small businesses are now asking whether they can return to the simplified depreciation rules now that TFE has run its course. Simplified depreciation is their preferred method going forward because it is simpler to use, it generally results in a faster write-off for depreciating assets and it gives a better outcome when high-cost assets are traded in or sold.
The ATO has, in various places, stated that the five-year lock-out rules have been suspended until 30 June 2023. For example, ATO webpage QC 33726 states:
From 7.30pm AEST 12 May 2015 to 30 June 2023 the ‘lock out’ rules are suspended to allow small businesses that have chosen to stop using the simplified depreciation rules to take advantage of temporary full expensing and the instant asset write-off.
The same language is used in the ATO’s Guide to depreciating assets 2022, at page 36.
It is not clear that these statements are quite correct since simplified depreciation technically continued to operate for small business entities during the TFE regime – it’s just that there were no limits on the IAWO or the writing off of GLVP balances during this period. This was achieved through s 328-181 of the Income Tax (Transitional Provisions) Act 1997 modifying s 328-180 ITAA 1997 by removing any existing limits for newly acquired depreciating assets over the 6 October 2020 to 30 June 2023 period, as well as the write-off thresholds for the GLVP balance.
Nevertheless, we would expect the ATO to adhere to its public statements and allow taxpayers that have previously opted not to use the simplified depreciation rules up to 30 June 2023 to re-enter the regime for 2024 if they wish.
Moving from Division 40 depreciation to simplified depreciation involves picking up the adjusted taxable values (tax written down values) as at 30 June 2023 for all Division 40 assets, the total amount converting to the opening GLVP balance as at 1 July 2023. This will be written off at 30% unless the balance of the pool is below $20,000 in which case it is deducted in full.
The abolition of TFE, replaced by simplified depreciation, does not reduce your depreciation deductions. Rather, it impacts cashflow (which can be quite a problem for small businesses). That is, instead of being able to claim all of your deductions upfront under TFE, your deductions under simplified depreciation may be spread out over a number of years for items which exceed the current write-off threshold of $20,000.
Temporary Full Expensing
Introduced as a central part of the government’s economic stimulus in the early stages of the COVID-19 pandemic, TFE prevailed over the Instant Asset Write-off (IAWO) and General Low Value Pool (GLVP) since its inception on 6 October 2020.
TFE had the effect of creating an immediate 100% deduction for eligible taxpayers (in business with a turnover below $5 billion) for pretty well all depreciating assets first used since 6 October 2020 through to 30 June 2023. The whole of the GLVP balance was also fully deductible as at 30 June 2021, 2022 and 2023, with no cap.
To be eligible for temporary full expensing, you had to fall into one of the following categories:
- A business whose total combined income is below $5 billion.
- A corporate tax entity that satisfies the alternative income criteria.
For the income years 2020-21, 2021-22, and 2022-23, eligible entities could claim a deduction in their tax return for the business portion of the cost of the following:
1. Qualifying new assets: These are assets that are initially acquired, utilized, or set up and prepared for use for a taxable purpose between 7.30 pm AEDT on 6 October 2020 and 30 June 2023.
2. Qualifying used assets: If the asset was originally acquired, used, or installed and ready for use for a taxable purpose between 7.30 pm AEDT on 6 October 2020 and 30 June 2023, and the combined turnover of the entity is below $50 million.
3. Improvements to eligible assets: This includes costs incurred between 7.30 pm AEDT on 6 October 2020 and 30 June 2023 for improvements to eligible assets.
4. Existing assets of small business entities using simplified depreciation rules: This applies to assets held by small business entities using the simplified depreciation rules and the balance of their small business pool.
Under temporary full expensing, generating a tax loss in an income year was possible due to claiming an immediate deduction. Corporate tax entities had an alternative option called “loss carryback” instead of carrying the tax loss forward to offset future income. Loss carryback allowed eligible entities to receive a refundable tax offset potentially.
Capital Works Deductions
Capital works deductions apply to specific activities and involve the gradual write-off of buildings, structural improvements, and other capital assets over a longer period than other depreciable assets.
How Can You Use Capital Works Deductions
Capital works deductions can be claimed for the following types of assets used to generate income:
- Buildings, which encompass any construction, extensions, modifications, or enhancements made to a structure.
- Enhancements and alterations were done to a leased building, including shop fit-outs and improvements specific to the lease agreement.
- Structural improvements involving the installation of sealed driveways, fences, and retaining walls.
- Earthworks undertaken for environmental preservation, such as constructing embankments.
It should be noted that the expenses associated with acquiring the land itself are not eligible for deduction.
Claiming Construction Cost Deductions
Several factors come into play when claiming deductions for construction costs of capital works. These factors include
- the commencement date of the construction
- the type of capital works involved
- how they are utilized
The applicable deduction rates for construction costs are either 2.5% or 4.0%, depending on the specific circumstances.
In situations where determining the exact construction costs is not feasible, obtaining an estimate from a qualified independent professional, such as a quantity surveyor, is permissible. In such cases, the full costs incurred for obtaining the estimate can be claimed as a deduction in the year they are incurred.
Deductions for Leasehold Improvements
Leasehold improvements, such as shop fit-outs, are categorized as capital works and cannot be deducted over their effective life or the duration of the lease. Instead, they must be claimed at the statutory rate of either 2.5% or 4.0%, depending on the applicable rate.
In the event that leasehold improvements are destroyed upon the expiration of the lease, it is possible to claim a balancing deduction in the year when the destruction takes place. It’s important to note that this treatment differs from general accounting practices.
How to Work Out the Correct Deduction
You can utilize the Depreciation and Capital Allowances tool to determine the appropriate capital works deduction that applies to your situation. This tool enables you to calculate depreciation amounts for rental properties by either adding the property under the Rental Property tab and entering the relevant assets or by adding the assets directly under the Asset tab, selecting the appropriate Type as “Net income or loss from business.
Deductions for Other Capital Assets and Expenses
This section explores various deductions available for capital assets and expenses, helping you make the most of tax benefits. From setting up or ceasing a business to in-house software and vehicle expenses, understanding and utilizing these deductions can help you reduce taxable income and enhance your financial position. Let’s discuss this one by one:
Deductions for Business Setup Costs
When setting up or changing the structure of a business, you can claim deductions for the associated costs. These expenses may include:
- the establishment of a company or other business structure
- converting your business structure to a different type
- raising equity for your business
- defending against takeovers
- attempting takeovers
- or ceasing business operations
However, it’s important to note that these costs should not be deductible under any other part of the tax law or considered as part of the cost of a depreciating asset or land.
To claim these deductions, you can spread the expenses over five years on a straight-line basis, deducting 20% of the costs in the year you incur them and the following four years.
Certain capital expenses directly related to a project can also be claimed as deductions. These expenses typically include feasibility studies or environmental assessments undertaken in relation to the project.
To account for these costs, you can allocate them to a pool and write them off over the effective life of the project using the diminishing value method. Similar to other deductions, these expenses should not be deductible under any other part of the tax law or considered as part of the cost of a depreciating asset or land.
If you engage in landcare operations on rural land used for primary production or other business purposes (excluding mining or quarrying), you can claim an immediate deduction for the capital spending involved. This deduction applies even if you lease the land from the owner.
Landcare operations involve activities aimed at environmental protection, such as conserving soil, improving water quality, or managing vegetation. However, it’s essential to ensure that the deduction is not claimed for expenses that are already considered as part of the cost of a depreciating asset.
Electricity and Phone Connections
You can deduct capital expenditure incurred on mains electricity or telephone connections for business purposes over a period of 10 years. This deduction applies to expenses related to connecting, upgrading, or extending the electricity supply to land on which a business is carried on, as well as connecting or extending telephone lines for land exclusively used for primary production.
It’s worth noting that in the case of partnerships, deductions for these expenses are allocated to individual partners rather than the partnership itself. Small business entities can choose between these special rules for depreciating assets or opt for the simpler depreciation rules.
Environmental Protection Activities
You can claim immediate deductions for expenditures incurred for environmental protection activities (EPAs) to prevent, fight, and remedy pollution and waste. EPAs include actions to prevent pollution, treat and clean up waste, and store waste from your earning activity. These activities should be directly related to your business operations, which can involve producing assessable income (excluding net capital gain), exploration or prospecting, or mining site rehabilitation.
Additionally, if you lease or grant the right to use a site and pollution or waste is caused by another entity, you may still claim a deduction for EPAs relating to that site. However, any expenditure already deductible as part of the cost of a depreciating asset cannot be claimed as an EPA expenditure.
For businesses engaged in exploration or prospecting activities for minerals, petroleum, or quarry materials, the full cost of depreciating assets used in these activities are deductible in the year you start using them. This immediate deduction applies to the exploration or prospecting costs incurred and capital expenditure on the rehabilitation of mining or quarrying sites.
You must also note that the deductible costs should not form part of the depreciating asset’s cost.
Special rules apply regarding deductions for in-house software acquired or developed for business use (not for sale). Depending on the circumstances, expenses related to in-house software can be deducted in various ways. You can claim these deductions through simplified depreciation for small businesses, general small business pools, the prime cost method, or software development pools.
Also, remember that periodic payments made to use software in your business are deductible in the year incurred. However, it’s crucial to understand and follow the specific rules and guidelines about deductions for in-house software expenses.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.