Tax deduction for repairs to an investment property

The ATO has identified several mistakes it commonly sees in tax returns which are made by people who own rental properties. One of those mistakes is claiming a deduction for repairs of a property when an outright deduction should not have been claimed.

An important issue is whether the expenditure on the property is of a capital nature or not. Making this distinction is not always easy and can be the cause of some of the mistakes.

The classic illustration used to distinguish between an item that is on capital account versus on revenue account is the ‘fruit and the tree’. The tree represents the capital or the income earning structure. The fruit represents what the tree produces. The fruit re-grows and is akin to the income, but the tree remains from year to year.

Applying this idea to a rental property, the structure of the property is the capital and recurring expenses or expenses that don’t add to the capital structure are on revenue account. As a general statement, capital expenses must be written off for tax purposes over several years, depending on what part of the structure we are referring to. Expenses incurred that do not add to the capital structure can be written off for tax purposes immediately.

Example: There is a burst water pipe on the property, and you call in a plumber to fix the problem. The plumber replaces part of the pipe and performs some related tasks. This is an expense that does not add to the capital structure of the property. It merely returns the property to its former, functioning state.

Example: The water pipes on the property burst in several spots. You decide that the whole plumbing system of the property needs replacement. You instruct the plumber to take out all the pipes and replace them with a new plumbing system. This would be of a capital nature. This is because you have replaced the whole of the plumbing system. This purchase is capital works and is depreciated over 40 years.

Another aspect of claiming a tax deduction for repairs that people are often unaware of is the inability to claim a tax deduction for initial repairs. Initial repairs refer to expenses incurred to rectify damage or defects that existed when the property was purchased. If you make good items that were in disrepair when you purchased the property, it is considered that you are spending money that should have been spent by the prior owner. Accordingly, these expenses are seen as a cost of acquiring the property and these need to be added to the cost base of the property for capital gains purposes. When the property is eventually sold, you will, effectively, get a tax deduction for the expenses at that time.

Example: You purchase a rental property, and the kitchen cabinets are damaged. If you replace or repair the cabinets before renting out the property, the expense is classified as initial repairs and is not deductible. However, it may be added to the property’s cost base for CGT purposes.

Another issue to contend with when undertaking repairs is whether you are repairing or improving the subject of the repair. When repairs are made using new materials, the deductibility depends on whether the repair restores the item to its original

condition or results in an improvement. An improvement in the asset is not considered to be a repair and is not immediately deductible.

Example: You replace a section of damaged roof tiles with new tiles of similar type and quality. This expense is deductible.

If you replaced the entire roof with modern materials that are more durable than the original structure, this expense would not be immediately deductible. This would need to be written off as a capital improvement.

A further issue to be considered is whether the ‘repair’ is of part of an item or whether it is replacing the whole item. If the repair involves replacing the entire asset, it is considered capital expenditure and is not immediately deductible. Sometimes this can be a difficult to determine.

Example: You replace some floorboards in a bedroom due to damage. This is an immediately deductible repair. If you decided to replace all the floorboards in a house, this would be a ‘repair’ of the ‘whole’ and would be of a capital nature.

One thing to remember, which isn’t about repairs, is the change that occurred in relation to second hand assets used in a rental property. This relates to depreciating items that were in a rental property when you purchased it. You can't claim a deduction for the decline in value for these types of assets if you entered into a contract to purchase that property on or after 7:30 pm (AEST) on 9 May 2017.

If you turn your home into a residential rental property on or after 1 July 2017, you can't claim a deduction for the decline in value for depreciating assets that were in your home. You can only claim a deduction for the decline in value for any new depreciating assets that you purchase for your residential rental property.

Disclaimer: This content provides general information only, current at the time of production. Any advice in it has been prepared without taking into account your personal circumstances. You should seek professional advice before acting on any material.