The difference between repairs and improvements can be confusing for property investors.
I mean… what is a repair? When does a repair become an improvement?
And how do you know what’s tax-deductible and what isn’t?
Fortunately, the Australian Tax Office sheds some light on these questions.
A repair replaces a part of something or corrects something that’s already there and has become worn out or dilapidated.
It’s usually occasional or partial and involves restoring something to its original efficiency.
Repairs make good damage that has occurred through normal wear and tear accidental or deliberate damage, or through the effects of natural causes.
Note, however, that repairs are generally partial.
Replacing a faulty filter in a dishwasher may be a repair; replacing the dishwasher generally is not.
You may be able to claim an immediate deduction for expenditure on repairs if you’re using your property to generate income.
However, if you’re claiming repairs as a deduction, you must be aware there is a difference between a repair and an improvement, as you cannot claim an immediate deduction for improvements.
But you may be able to claim a capital works deduction for improvements.
Although there’s a difference between ‘maintenance’ and repair, you can generally claim an immediate deduction for maintenance costs.
Quite often when you buy a rental property, there may be defects that need to be fixed before your first tenants can move in.
A repair is not an initial repair simply because it’s the first repair made after you acquired your property.
Broadly, it’s an initial repair if the defects, damage or deterioration in need of repair existed when you acquired the property.
In other words, if you buy a 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, not the cost of repairing defects that arose while you were renting it.
You can’t claim an immediate deduction for initial repairs, even if you start to rent the property before you carry out the repairs.
Generally, the cost of the initial repairs may be included in the capital gains tax cost base of your rental property.
The difference is that generally, repairs made to defects that arise while our property is producing income are tax-deductible, while initial repairs are not because they lack a connection with your use of the property to produce income.
Essentially, an initial repair is an additional cost of acquiring your property or an improvement to the property.
If you’ve spent money on fixing a problem that existed when you bought the property, it’s a capital expenditure, even if your tenants move in before you make the initial repair.
It doesn’t matter whether or not you knew the property needed initial repairs when you acquired it, or whether the purchase price of your property reflected the need for repairs.
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Where a repair simply restores something to its original state, an improvement makes something better than it was originally.
Generally, an improvement makes something function more efficiently than it used to and will increase a property’s market value or extend its income-producing potential.
It involves bringing a thing or structure into a more valuable or desirable form, state or condition than a mere repair would do, such as remodelling kitchens or bathrooms, or extending the size of a house.
To distinguish between a repair and an improvement, you need to consider the effect the work done on the property has on its efficiency of function.
Improvements will generally come under the heading of capital works, so you may be able to claim a capital works deduction.
Capital works deductions can be claimed over a number of years, and the amount you can claim depends on the type of construction and the date construction commenced.
While reconstruction of a whole capital item (such as a fence) is not a deductible repair, a “progressive restoration” could be undertaken over a period of time that progressively restores damaged individual parts of the whole.
The progressive restoration could be classed as a series of deductible repairs.
In drawing the line between a series of repairs and a restoration of the entirety (or an improvement), you would need to consider:
- The nature, scale and size of the work in proportion to the nature, scale and size of the property involved (generally the larger the work in comparison with the size of the property, the more likely the work is to be an improvement);
- The period of time over which the work is done (the shorter the period, the more likely it is to be an improvement), and
- Whether the work is done as an ongoing program of restoration (more likely to be a series of deductible repairs) or done in one operation (more likely to be an improvement).
For example, if a damaged fence was replaced in sections over a number of months, it could be a repair. If the entire fence is replaced at one time, it’s more likely to be an improvement.
If you own a rental property, you can deduct certain kinds of construction expenditures.
These are called capital works deductions, and would generally be spread over a period of 25 or 40 years.
Your total capital works deductions can’t exceed the construction expenditure, and you can’t claim a deduction before the construction is complete.
Deductions based on construction expenditure apply to capital works such as:
- A building or an extension – for example, adding a room, garage, patio or pergola;
- Alterations – such as removing or adding an internal wall; or
- Structural improvements to the property, for example, adding a gazebo, carport, sealed driveway, retaining wall or fence. However, landscaping is not a structural improvement.
If you only rent your property for part of the year, you can claim a partial capital works deduction.
If you can claim capital works deductions, the construction expenditure on which those deductions are based can’t be taken into account when you work out any other types of deductions for a decline in the value of depreciating assets.
Make sure you’re getting all the tax benefits of your investment property, so in order to substantiate a claim for any of these deductions you’ll need to have everything well documented.
The ATO requires that you keep records for:
- The property’s rental income
- The deductible expenses you pay
- All costs of purchasing and acquiring the property
- Conveyancing contracts
- All loan documentation
As with any tax matter, it’s always best to seek out the help of a property-savvy accountant.
Note: This is a general summary only – you can get more information from the ATO here or form a registered tax professional