Depreciation: How It Works — Methods, Tax & Examples

Updated 12 Mar 2026Content was accurate at the time of publication

Depreciation is one of the most misunderstood but important concepts for business owners, property investors and anyone who buys assets for income-producing use. This practical guide answers: what is depreciation, how to calculate it for tax and accounting, which ATO rules matter, and what records you must keep. Read step-by-step examples (prime cost and diminishing value), clear ATO references (effective life, pooling, instant write-offs) and a concise cheat sheet you can use when preparing returns or talking to your tax agent.

What is depreciation?

Depreciation is the systematic allocation of the cost of a depreciating asset over its effective life. It reflects the decline in value of an asset used to produce assessable income — whether through wear and tear, obsolescence, or time.

Key distinctions:

Accounting depreciation: spreads cost across reporting periods to match revenue and expense (profit and loss impact).
Tax depreciation (decline in value): ATO rules determine how much you can deduct each income year for tax purposes. Tax depreciation often follows different rates or methods than accounting depreciation.

A depreciating asset is generally tangible property with a limited effective life — land is excluded because it does not decline in value by use or time.

Why depreciation matters (for accounting and tax)

Depreciation affects three practical areas you care about:

Profit and performance: Depreciation reduces accounting profit over time, aligning expenses with revenue generation.
Taxable income and cash flow: Tax depreciation reduces taxable income and therefore tax payable, changing cash flow timing (not the initial cash outlay).
Asset management and replacement planning: Recognising depreciation helps you budget for replacement and decide whether to repair, upgrade, or replace equipment.

Understanding accounting vs tax depreciation avoids surprises in financial statements versus tax liabilities. For rental properties, claiming depreciation on plant & equipment and capital works can materially improve after-tax returns — but specific ATO rules and documentation (e.g., quantity surveyor reports) may be needed.

Types of depreciable assets

Common classes:

Plant and equipment (machinery, tools, office furniture, business vehicles)
Fixtures and fittings (kitchen fit-outs, built-in cupboards)
Capital works (building structural improvements, hot water systems)
Intangible depreciating assets (software with a finite life)
Horticultural plants and grapevines (special ATO rules)

Exceptions:

Land (not depreciable)
Assets that don't decline in value through use
Trading stock (handled separately)

See ATO guidance for full definitions and examples: https://www.ato.gov.au/business/depreciating-assets-and-capital-expenses

Depreciation methods (how it's calculated)

Common methods:

Prime cost (straight-line)
Diminishing value (declining balance)
Units of production (usage-based)

The ATO lets taxpayers choose the method that best reflects the decline in value, but specific rules and consistency requirements apply.

Advantages at a glance:

Prime cost: predictable, even expense each year — useful for budgeting and accounting.
Diminishing value: larger deductions earlier — often better for tax timing and cash flow.
Units of production: best when decline equals usage (e.g., machine hours).

Prime cost (formula and worked example)

Formula (full year)

Annual depreciation = Cost × (1 / Effective life)

Pro-rata if held part of year:

Depreciation for year = Cost × (Days held / 365) × (1 / Effective life)

Worked example (business asset)

Asset cost: $15,000
Effective life: 5 years
Method: Prime cost
Days held in first year: 270

Calculation:

Annual rate = 1 / 5 = 20%
Pro-rata first year = $15,000 × (270/365) × 20% ≈ $1,219

Subsequent full years: $15,000 × 20% = $1,000 per year until the asset is written off or disposed.

Diminishing value (formula and worked example)

Formula (ATO DV approach, full year simplified)

Decline in value (full year) = Opening adjustable value × (200% / Effective life)

Pro-rata if held part of year:

Decline in value = Opening adjustable value × (Days held / 365) × (200% / Effective life)

Worked example (same asset)

Opening adjustable value: $15,000
Effective life: 5 years → DV rate = 200% / 5 = 40%
Days held first year: 270

Calculation:

Decline in value = $15,000 × (270/365) × 40% ≈ $1,438

Year two opening value = $15,000 − $1,438 = $10,562; decline is calculated on the new opening value.

When to use DV: when you want larger early deductions for tax timing; prime cost is preferred for even expense recognition.

Compare methods:

Method	Annual full-year calculation	Typical use
Prime cost	Cost × (1 / Effective life)	Even expense, accounting parity
Diminishing value	Opening value × (200% / Effective life)	Faster tax deductions early
Units of production	Cost × (Units used / Total estimated units)	Usage-based assets

ATO rules and important tax concepts

Key ATO topics you must know:

Effective life: The ATO publishes effective life tables. You can use the ATO's statutory effective life or self-assess a different life if you can justify it. Lookup: https://www.ato.gov.au/general/depreciation-and-capital-expenses/effective-life/

Division 40 vs Division 43:
- Division 40 covers plant & equipment (decline in value).
- Division 43 covers capital works (building and structural improvements) claimed as capital works deductions (typically over 25–40 years).

Low-value assets and the low-value pool:
- Assets under the ATO threshold can be immediately deducted or placed in a low-value pool. Small business concessions allow pooling of assets. Check current thresholds: https://www.ato.gov.au/business/depreciation-and-capital-expenses

Temporary full expensing / instant asset write-off:
- Temporary measures allowed eligible businesses to deduct the cost of eligible assets in the year they were first used or installed ready for use. Rules and date ranges vary — check the ATO: https://www.ato.gov.au/business/depreciation-and-capital-expenses/temporary-full-expensing/

Second-hand assets: You can claim decline in value on second-hand assets from the date you start using them to produce income. Opening adjustable value is generally your cost.

Apportioning private use: If an asset is used partly for private purposes, apportion the deduction. Keep records to support the business use percentage.

Small business pooling rules: Eligible small businesses may allocate assets to a small business pool, depreciated at a set rate.

External guidance:

ATO — Depreciating assets and claim rules: https://www.ato.gov.au/business/depreciating-assets-and-capital-expenses
ATO — Deductions for depreciating assets: https://www.ato.gov.au/business/income-deductions-and-concessions/income-and-deductions-for-business/deductions/deductions-for-depreciating-assets-and-capital-expenses

Practical note: ATO rates and incentives change — temporary measures have defined date ranges, so always verify current rules.

How to claim depreciation in your tax return (practical steps)

Step-by-step:

Identify and classify the asset (Division 40 plant & equipment vs Division 43 capital works).
Determine cost base: purchase price plus incidental costs (installation, transport, delivery).
Choose a depreciation method (prime cost or diminishing value) and determine effective life (ATO table or self-assessed and documented).
Calculate decline in value, pro-rata by days held and apportion by business use percentage.
Enter amounts on the appropriate tax return schedules (business/rental property) or supply totals to your tax agent. Rental property deductions are reported separately.
Keep records: invoices, purchase contracts, dates of first use, calculations and evidence of apportionment.

Record-keeping checklist:

Purchase invoices and receipts
Date asset was first used/installed ready for use
Evidence of business vs private use (logbooks for vehicles, usage logs)
Depreciation schedules and calculation workpapers
Quantity surveyor reports for rental property capital works and plant & equipment (if used)

When to get a quantity surveyor: For rental properties where capital works and plant & equipment depreciation claims are significant — especially older properties — a qualified quantity surveyor can prepare a depreciation schedule acceptable to the ATO.

When acquiring high-cost assets, you may find equipment finance or asset finance options relevant.

Special cases and common asset examples

Horticultural plants (e.g., grapevines): special ATO rules assign specific effective lives and methods — often prime cost over the plant's bearing life.
Fencing and water facilities: classification depends on permanence and nature — may be Division 43 or Division 40.
Software: treated as a depreciating asset if it has a limited effective life. Off-the-shelf software may be immediately deductible under certain thresholds.
Low-value assets: items below the low-value threshold can often be written off immediately or placed in a pool.
Second-hand assets: deductible based on cost to you and date of first use.

Example quick cases:

Buy a $100 asset used 100% for business — if the low-value immediate deduction threshold applies, you may claim the full $100 in the year of purchase.
A rental property with older fixtures may require a quantity surveyor to identify remaining effective lives and allowable deductions.

Common mistakes and pitfalls

Mis-classification (treating capital works as plant and vice versa).
Using an inappropriate effective life (ATO may adjust if unrealistic).
Double dipping (claiming the same expense as both a repair and depreciation).
Failing to apportion for private use (vehicle or mixed-use assets).
Missing temporary measure deadlines (instant asset write-off / temporary full expensing).
Poor record-keeping — lack of invoices or dates is an audit trigger.

Key tip: maintain a depreciation schedule that records cost, purchase date, method, effective life, opening and closing values, and yearly deductions.

Quick reference: formulas and cheat sheet

Formulas (plain text):

Prime cost (full year): Annual depreciation = Cost × (1 / Effective life)
Prime cost (pro-rata): Depreciation = Cost × (Days held / 365) × (1 / Effective life)
Diminishing value (pro-rata): Decline in value = Opening value × (Days held / 365) × (200% / Effective life)
Units of production: Depreciation = Cost × (Units used / Total estimated units)

When to use which method:

Prime cost for even spread (accounting parity).
Diminishing value for faster tax deductions early (cash flow advantage).
Units of production when decline equals usage.

Where to find effective life:

ATO effective life tables: https://www.ato.gov.au/general/depreciation-and-capital-expenses/effective-life/
If an asset is not listed, use the closest comparable asset or self-assess with supporting documentation.

Cheat: DV gives front-ended deductions; prime cost gives straight-line.

FAQ

What assets can't be depreciated?

Land is not depreciable. Also, assets that do not decline in value by use or time generally aren't depreciating assets. Trading stock is handled separately.

Can you claim depreciation on second-hand assets?

Yes. You can claim decline in value from the date you first use the asset to produce income. The opening adjustable value for tax purposes is generally your cost.

Which depreciation method is better for tax?

Diminishing value typically provides larger deductions earlier, improving near-term cash flow. Prime cost spreads deductions evenly. Choice depends on your tax position and cash-flow needs.

What is effective life?

Effective life is the ATO's estimate of how long an asset can be used to produce income. You can use the ATO's published tables or self-assess if justified. Incorrect selection can lead to adjustments.

How long must I keep records?

Keep records for at least five years after you lodge the tax return that records the transactions, but longer retention is prudent for asset registers and property depreciation schedules. Maintain invoices, dates of first use, calculation workpapers, and evidence of business use.

Do I need a quantity surveyor for rental property?

Not always. For older properties or complex claims (capital works and plant & equipment), a quantity surveyor's depreciation schedule is commonly used to substantiate claims.

How does temporary full expensing interact with depreciation?

Where eligible, temporary full expensing allows immediate deduction of the cost of eligible assets instead of claiming depreciation over time. Eligibility and date ranges vary; always confirm current ATO rules: https://www.ato.gov.au/business/depreciation-and-capital-expenses/temporary-full-expensing/

Key takeaways

Depreciation is a systematic way to claim deductions for the decline in value of business assets over time. Both accounting and tax depreciation matter: accounting depreciation affects profit reporting, while tax depreciation reduces your taxable income. Choose between prime cost (even deductions) and diminishing value (front-loaded deductions), calculate using ATO effective life tables, maintain detailed records, and verify eligibility for temporary concessions. For complex claims on rental properties, consider a quantity surveyor's depreciation schedule.