The ATO has identified common mistakes made by rental property owners in their tax returns. One frequent error is claiming an immediate deduction for repairs when such expenses should not qualify. A critical issue in these cases is determining whether the expense is of a capital nature. This distinction is not always straightforward as discover in this article.
Capital vs. Revenue Expenses
A classic analogy used to differentiate between capital and revenue expenses is the ‘fruit and the tree.’ The tree represents the capital—the income-generating structure—while the fruit symbolises the income it produces. Applying this to rental properties, the property structure is the capital and recurring or non-capital-enhancing expenses fall under revenue. Generally, capital expenses must be depreciated over time, while non-capital expenses can be deducted immediately.
Example 1: If a plumber replaces a section of a burst water pipe, restoring the property to its previous condition, this is a deductible expense.
Example 2: Replacing an entire plumbing system, however, constitutes capital expenditure, as it significantly enhances the property. This cost must be depreciated, often over 40 years.
Initial Repairs
Another common misunderstanding involves initial repairs—expenses to fix pre-existing damage or defects when purchasing a property. These costs are not deductible but are instead added to the property’s cost base for capital gains tax (CGT) purposes.
Example: Replacing damaged kitchen cabinets in a newly purchased rental property before renting it out is considered an initial repair. These costs cannot be claimed as deductions but can be included in the CGT cost base.
Repairs vs. Improvements
The distinction between repairs and improvements is another key issue. Repairs restore an asset to its original condition, while improvements enhance it. Improvements are considered capital expenses and are not immediately deductible.
Example 1: Replacing damaged roof tiles with similar materials qualifies as a deductible repair.
Example 2: Replacing the entire roof with more durable modern materials is an improvement and must be depreciated.
Additionally, replacing part of an item is generally deductible, while replacing the whole item is treated as a capital expense.
Example 1: Replacing a few damaged floorboards in a bedroom is deductible.
Example 2: Replacing all the floorboards in a house is a capital expense, as it involves the entire asset.
Depreciation of Second-Hand Assets
For contracts entered into after 7:30 pm (AEST) on 9 May 2017, deductions for the decline in value of second-hand depreciating assets in rental properties are no longer allowed. Similarly, if a property previously used as your home is converted into a rental property on or after 1 July 2017, deductions for existing depreciating assets are not permitted. Only newly purchased assets for the rental property can be depreciated.
Understanding these distinctions is vital for rental property owners to avoid errors in their tax returns and ensure compliance with ATO guidelines.
Ensure you’re utilising your tax deductions correctly.d Learn the key differences between repairs, capital improvements, and initial repairs for your rental property. Reach out to our tax accountants to get expert guidance on managing your property expenses effectively and staying compliant with ATO regulations.
