Depreciation: Prime Cost Method vs. Diminishing Value Method

We just received two extremely thorough depreciation reports (thanks @Depreciator - highly recommended!)

Normally we are all for delayed gratification and would chose the Prime Cost Method (PCM).

Given that we are at our serviceability limit, moving forward will be relying more on savings and won't be moving up tax brackets in the forseeable future we are thinking a better option would be to receive the higher depreciation benefit sooner under the Diminishing Value Method (DVM). The DVM method will provide an approximate additional depreciation benefit (not tax refund) of:

1st year - $700 (partial financial year)
2nd year - $1,900
3rd year - $1,500
4th year - $800

Around the 7th year the PCM benefit becomes greater than the DVM

What are your thoughts on Prime Cost vs. Diminishing Value?

 

I use the diminishing value method on my IPs as I want all the money I can get now in the short term to help improve my IPs and reduce my debt while its at its highest. There's bound to be benefits to using prime cost but I felt it wasn't for me.

 

I agree. We previously used Prime Cost but another investor made a comment to me that we should be more concerned with buying property as opposed to minor tax implications 10 years down the track which I tend to agree with.

 

Can you switch between the two? Or is it a case of whatever method you select at the start, you are stuck with that for the life of the property's depreciation?

 

I thought you could choose which method to use for each item. Once you have chosen, you must use that method for the depreciable life of that asset. I may be wrong on this though.

 

Accountant told me years ago that which ever method is chosen in the first year we had to stick to.

 

That would become fairly onerous on the accountant. Even if you can do this we will just be sticking with the total figures to keep it simple.

 

I reckon 99.9% of investors would use the DV method. It's in the early years when holding costs for a property tend be higher.

Scott

 

This is correct.

I think somebody made the same comment back in the Somersoft forum. In theory you can do this but it seems like a lot of trouble to go to in proportion to the potential benefit. You would also have to avoid using the low value pool if you tried to do this.

 

My advice to clients is to always use the diminishing value method unless otherwise advised.

There are rare and often trivial issues where deferring larger deductions to later years may provide some minor benefits however it also relies on unknown issues such as future tax rates, future total income etc. An example is a owner who buys a IP then finds themselves taking maternity etc leave and expects not to work for several years but this comes with some concerns :
- Tax laws may change
- Taxpayer position may vary from predictions
The strategy may be still to claim deductions as they occur and retain a tax free carried forward tax loss for future income.

I take the view that if a deduction is available today you take it as you know it is available but it may provide a different or no benefit in the future.

Of course the DVM only applies to Div 40 depreciation and Div 43 capital allowance always is calculated on a prime cost basis.Using PC also means there is no pooling.

I have attached two fairly typical examples that compare the two methods. Generally I see that the benefit of bringing forward deductions only affects the first 5-6 years when many investors are neg geared.

 

DV = improved cash flow

Alternatively, you can view the PC method as making an interest-free loan to the government.

 

I would rather my tax refund in today's money as much as possible, getting the bulk of it back once its halved its value is not ideal..

 

Just to add to Paul's comments above and the sample of a report he posted, it's worth having a look at page 10 of our sample report attached.

The line graph shows a scenario where the deductions start in 2014. You'll notice that the DV deductions dip below the PC ones from 2018 onward.

Now, let's say that for the first four financial years you lived in the property and only started renting it out in 2018. Which would you choose? DV doesn't look so good in that scenario. In fact, if you look at the previous page of the sample report, DV doesn't eclipse PC again until 2029, and from then on the difference between the two is mostly negligible. PC has its uses.

 

I liked the explanation in your BMT Maverick newsletter this edition.

It used the illustration of maximising deductions to enhance "higher income" and using that to reduce debt to further build equity or to put away for other personal use.

 

Good one BMT, this is something that I had never considered before.

 

Another new concept. This could help with debt recycling and compounding.

 

The most common situation where a choice is made to use PC is companies or trusts with carry-forward tax losses.