When investing in property for a short or long term it is important to understand the effects of property depreciation and how it can change an investment.
The Australian Taxation Office (ATO) allows investors to use two alternative methods of depreciation.
1- Diminishing Value Method- accelerates deductions quickly
2- Prime Cost Method- spreads the deductions out over time.
The long term intentions of the property investor will determine which depreciation method will be suitable for them. An investor must decide to use only one method; each method effects the long term cash flow position in a different way. Under the Diminishing Value method the deduction is calculated as a percentage of the balance you have left to deduct. The deductions will be higher in the first five years and diminish over time. This is because you are claiming a greater proportion of the asset’s cost 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 result in a more even spread deductions over a longer time. It depends on your investment strategy as to which method is best for you, you will need to consider how long you intend to hold the property and if you are going to need higher deductions now or in ten years time. Your accountant is the best person to discuss this with.
If an investor purchases a property for the purposes of a short term investment and planned to sell it in approximately five years, the Diminishing Value method may be a more attractive option to take, as it provides higher returns over the earlier years. If the owner was intending to retain ownership for a longer period of time then the Prime Cost option may be more suitable, as it provides a constant long term projection of what the investor’s tax deductions will be.
Through BMT’S experience it shows that most investors employ the Diminishing Value method on both long and short term investments as depreciation deductions under this method are cumulatively higher over the first five of ownership, when they need the deductions most.
Remember to discuss these options with your accountant, every property investor’s situation is different, your accountant will know which method is best for you.