The ATO have recently come out saying that 9/10 tax returns containing a rental schedule are incorrect. Regardless of if this statistic means 9/10 of ALL rental property returns, or, 9/10 of the returns that the ATO have investigated; this is still a pretty large statistic!
What triggers an ATO investigation?
The ATO are focussing on what is entered into the tax deduction box “other rental deductions.” When this figure is high / above a certain range – especially at the moment, they will almost certainly investigate your tax return.
The MAIN issue that causes this figure to be high is repairs. As we’d all know – it’s pretty common to incur expensive repairs to your rental property, and you’re always going to hope that you can claim these repairs as a tax deduction. Unfortunately, just because you deem a cost a repair – does not mean that this is deductible in your tax return.
Claiming repairs as a tax deduction
S8-10 of the ITAA states that an expense is deductible when it is incurred in producing assessable income, or for the purpose of carrying on a business. However, if that expense is capital, domestic or private in nature, the expense cannot be claimed. More specifically, S25-10 of the act speaks about repairs to rental properties – with similar logic that the expense is deductible if it relates to generating taxable income UNLESS the expense is capital in nature.
So then, what does “Capital in nature” mean exactly?
Capital in nature, in the context of a rental property, refers to expenses that are incurred in establishing, altering, replacing, or enlarging the structure of the entity. These costs are lasting and recurring in nature, and they provide or bring into existence a lasting or recurring asset or advantage. These expenses are not deductible because they are considered to create or preserve the capital asset (the property) to provide an enduring advantage.
Here are some examples:
- Replacement of an entire structure, such as a complete fence or building.
- Installation of a new stove, kitchen cupboards, or refrigerator when it goes beyond simple repair and constitutes an upgrade or improvement.
- Improvements, renovations, extensions, and alterations to the property, like adding a new room or renovating the kitchen.
- Landscaping the garden to enhance the property’s appeal and value.
- Insulating the house to improve energy efficiency, which is a long-term improvement.
- Initial repairs to remedy defects, damage, or deterioration that existed at the time you acquired the property, as these are considered improvements to bring the property to a rentable condition.
These expenses typically provide a benefit over multiple years and may increase the value of the property or extend its useful life.
Incorrectly claiming repairs as a tax deduction
What is happening all too often – is that taxpayers are claiming costs that are considered capital (such as the examples above) – as repairs. One key aspect causing this confusion surrounds “initial repairs”. It may be well and good to deem that a cost is an actual repair -and thus deductible – HOWEVER, as above, if that cost is a repair to the initial structure of that property, then, in fact it is considered capital in nature and not directly deductible in your return.
So, how SHOULD capital expenses be treated then?
Items that are capital in nature are generally not deductible as an immediate expense in the year they are incurred. Instead, their cost may be depreciated over time or claimed as capital works deductions, depending on the nature of the expenditure:
Depreciating assets: The cost of capital items that are depreciating assets (like appliances or furniture) can be written off over the effective life of the asset, as decline in value deductions.
Capital works deductions: Structural improvements or building costs can be claimed as capital works deductions. This typically involves writing off the cost at a fixed rate (currently 2.5% per year) over a 40-year period for residential properties.
Cost base adjustments for CGT(Capital Gains Tax): Capital expenses may also form part of the cost base of the property for Capital Gains Tax (CGT) purposes, which can reduce the capital gain when the property is sold, provided these costs have not been claimed as a deduction elsewhere.
Checklist to determine if your repair cost is actually tax deductible
Ask yourself the following questions:
- Was the cost incurred for a repair? (Must be YES). A repair, in the context of a rental property, is work done to fix damage or deterioration of the property, and typically involves restoring something to its original condition without changing its character. Repairs are generally required to address wear and tear or damage that occurred as a result of renting out the property. Examples include replacing broken windows, maintaining plumbing, and repairing electrical appliances. These are usually one-off fixes that keep the property in a tenantable condition and do not provide a significant long-term improvement or enhancement to the property.
- Is the repair to the premises or a depreciating asset of the premises? (Must be YES).
- Is the repair of a capital nature? (Replacement of an entirety / improvement, initial repairs (see above) (Must be NO). A replacement of entirety in the context of a rental property refers to the complete replacement of a structure or unit of property, rather than just repairing a part of it. This could involve replacing an entire fence, roof, or building, rather than just fixing a section of it. It also includes replacing a significant component of the property, such as a stove, kitchen cupboards, or refrigerator, where the new item constitutes an upgrade or improvement over the old one. These types of replacements are considered capital in nature because they go beyond simple repairs and often enhance the value of the property or extend it’s useful life.
- Was the item used solely for the purposes of producing assessable income? If the answer is YES, then the item is tax deductible. If the answer to this question is “no” a deduction may be available if it is reasonable in some circumstances.
Navigating the complexities of tax deductions for rental properties can be fraught with confusion and pitfalls. The distinction between repairs, which are generally deductible, and capital improvements, which are not immediately deductible, is a critical point of confusion for many property owners. Understanding the difference is essential to ensure compliance and to avoid the costly consequences of an ATO audit.
Need help determining the deductibility of your investment property renovations?
Be sure to exercise due diligence in classifying your expenses, keep meticulous records, and don’t hesitate to get in touch with our team. At Freshwater Tax, we ensure that you maximise your tax outcome, while ensuring that the complex rental property tax laws are adhered to.
