In addition to over-claimed interest, incorrect apportioning of holiday home expenses, and the omission of income from accommodation sharing, the ATO’s in-depth audits have also focused on capital improvements incorrectly claimed as repairs.
Even though repairs, maintenance and capital improvements are all legitimate tax deductions for property investors, it’s very important to understand the differences when it comes to lodging claims for these items.
Keep in mind that if you’re renovating your property, it’s likely that you will need to claim for a combination of repairs, replacements, maintenance and capital improvements, so keeping clear and detailed records is key! Huge numbers of incorrect and unjustified claims are the reason the ATO has recently doubled the number of audits on property investors.
Let’s get clear on the differences between repairs, maintenance and capital improvements so that you can steer clear of ATO penalties and get the most out of your investment property.
Does your investment property have a hole in the wall, a leaking tap, or some cracked tiles? You need repairs!
Repairs are works done to the property that specifically fix damage or deterioration, and are fully tax deductible when property investors make a claim in the same financial year. However, to be eligible for an immediate tax deduction, the damage that needs repairing must be a direct result of your property being used to generate rental income.
In other words, the damage must have occurred while you have tenants in the property, or while the property is available for rent. In this case, 100% of the amount spent on repairs will be deducted from your taxable rental income for the year. This damage could be caused by normal wear and tear, accidental or deliberate damage, or through the effects of natural causes.
To elaborate a little further, repairs are generally a partial replacement of something to restore it to its original function and efficiency. For example, replacing a broken filter in your dishwasher is a considered a repair for tax purposes, while replacing the whole dishwasher is not.
In some cases, you might choose to replace the entire damaged asset. The old asset can be written off in full, which means that in addition to any service fees, you can also claim the remaining value of this asset according to its depreciation schedule. For separately identifiable assets within the property, such as ovens, heaters, air conditioners and hot water heaters, you can claim the decline in value each financial year for the effective life of the asset if you purchased it brand new.
- Once the replacement asset is purchased, and installed ready for use, depreciation will commence for the total amount. For major works its a good idea to have a depreciation schedule prepared by a licences surveyor to keep a clear and accurate record!
- Keep in mind that secondhand items are no longer deductible.
Need to mow the lawn and do the gardening? Or perhaps it’s time to clean the gutters, service the heater or paint the internal walls?
These are some of the many activities that fall under maintenance. Like repairs, maintenance costs are also 100% tax deductible. The difference is that maintenance involves work that prevents damage and deterioration to the property, keeping it in a tenantable condition.
If you’re using your property to generate income, it’s possible to claim an immediate deduction when you spend money on maintenance.
Want to replace the entire roof, remodel the kitchen, build a nicer fence, knock out an unnecessary wall, or build a deck? These are capital improvements, and they’re quite different to maintenance and repairs.
Where maintenance prevents deterioration and repairs restore something to its original state, an improvement makes something better than it was at the time of purchase. As such, capital improvements include repairs to damage that existed at the time of purchase.
A capital improvement makes something function more efficiently than it used to and will increase the market value or the income-producing potential of your investment property. For this reason, an immediate deduction is not available. However, these improvements depreciate over time, and are usually deductible at 2.5% or 4% per year for 40 years from the date construction was completed. This is known as a capital works deduction, and the amount you can claim depends on the type of construction, as well as the start date of construction.
Let’s clarify the difference between a repair and a capital improvement with an example.
If you replace a damaged fence in sections over a number of months, it would be considered a repair. However, if the entire fence was replaced all at once, it’s more likely to be considered a capital improvement.
Why these deductions don’t apply in the first 12 months
If you’re looking at buying an investment property, it’s so important to look out for any assets that might need replacing or repairs that need to be done before you can rent it out. Any work done to your property in the first 12 months will almost always be considered capital improvements, even if your tenants move in before you make the initial repairs.
If you do notice any need for repairs or replacements, be sure to negotiate a reduction in the purchase price. In the eyes of the ATO, the cost of any necessary repairs or maintenance has been factored into the purchase price, regardless of whether it actually was.
In other words, when you buy an investment property to generate income, the cost of bringing that property to a state where it’s suitable for tenants is considered part of the cost of its acquisition, rather than a standard repair cost.
There are a couple of exceptions to this rule. If you need to repair damage caused by the tenant during the first twelve months, the ATO will view those costs as a repair and you may be eligible for an immediate tax deduction. The same applies if you need to do repairs to the property after a storm.
- Initial repairs are not tax deductible because they aren’t directly associated with your use of the property to generate income, but you will be able to use the cost of your initial repairs to work out your profit when you sell the property.
- An initial repair is an additional cost of acquiring your property or an improvement to the property. But did you know the cost of the initial repairs may be included in the capital gains tax cost base of your investment property?
Keeping records is key!
One of the most important habits for property investors to get into is keeping records of all work undertaken on the property, no matter how big or small. The ATO’s number one cause of claim refusal is a lack of accurate records being kept, such as receipts and other documents to back up investor’s claims.
If you are doing renovations that involve both repairs and improvements at the same time, it’s important to separate these costs in your records.
- Ask your builder or Tradie to produce an itemised invoice to help you work out your claim. Without an itemised invoice, all costs will be treated as capital and written off over time with no immediate deductions.
- Remember that whatever you claim as a deduction will impact the amount of capital gains tax you need to pay.
- Bear in mind that the ATO have investment property owners on their radar at the moment, and making fake records can result in higher penalties and even prosecution.
To recap, if you repair or maintain something that is broken, damaged or at risk of deterioration, you are eligible for an immediate tax deduction. Improvements that increase your property’s value and income-generating potential, including repairs to damage that existed at the time of purchase, are not immediately deductible. Instead, these capital works costs are depreciated over the assets useful life.
This seems simple enough.
However, what may seem like a simple renovation can become quite complex when it comes to apportioning the correct tax deductions. This is why it’s so critical to discuss your renovation plans with your investment property tax specialist and ensure you record and claim correctly.
The property experts at ABA have a first-hand understanding of how repairs, maintenance and capital improvements are treated for tax purposes, and our friendly team can help you claim the correct property tax deductions to maximise your next return, as well as your long-term profits.