When it comes to claiming tax deductions for investment properties, the Australian Tax Office (ATO) often encounters common errors made by property owners. One frequent mistake is incorrectly claiming deductions for repairs that don't qualify for immediate tax benefits.
A key factor in determining whether you can claim a deduction is whether the expense is classified as capital or revenue. This distinction is not always straightforward, leading to confusion and errors.
To explain this distinction, the metaphor of "fruit and the tree" is commonly used. Here, the tree represents the property’s structure or capital, and the fruit symbolizes the income it generates. The fruit, which regrows every year, can be compared to recurring expenses, while the tree remains constant and represents the long-term capital investment in the property.
In terms of rental properties, costs related to maintaining or replacing the property's structure are generally considered capital expenses, while routine expenses that restore the property to its previous condition are considered revenue expenses. As a rule of thumb, capital expenses are written off over several years, depending on the type of work involved, whereas revenue expenses can be claimed in full in the year they're incurred.
Examples:
Repairing a Burst Water Pipe: If a pipe bursts and a plumber fixes it without changing the system, this is a revenue expense because it restores the property to its previous state.
Replacing the Entire Plumbing System: If you replace all the plumbing, this is considered a capital expense, as it improves the property’s structure. These costs are depreciated over 40 years.
Another critical aspect that many overlook is the inability to claim deductions for repairs that relate to issues present at the time of purchasing the property. These are considered initial repairs, as the costs are linked to the property's condition when acquired. Such expenses should be added to the property’s cost base for capital gains tax (CGT) purposes. When the property is sold, these costs are then considered during the sale for CGT calculation.
Example: If you buy a rental property and repair damaged kitchen cabinets before renting it out, the expense is categorized as an initial repair and cannot be deducted immediately. However, it can be added to the property’s cost base for CGT purposes.
Another area of confusion is whether a repair is truly a repair or an improvement. Replacing a damaged part with something similar to the original structure is typically considered a repair, which is deductible. However, if you replace the damaged item with a significantly upgraded version, it may be viewed as an improvement, and thus not eligible for an immediate deduction.
Example: Replacing a few damaged roof tiles with identical ones would be considered a repair and deductible. But if the entire roof is replaced with a more durable material, this is an improvement, not a repair, and would need to be treated as a capital expense.
Furthermore, it's important to distinguish between repairing part of an item versus replacing it entirely. If you replace an entire asset, the cost is typically viewed as a capital expense and is not deductible right away.
Example: Replacing the entire roof of a property, even with the same type of materials, is considered a capital expense and not deductible immediately.
Finally, there are specific rules regarding depreciation for second-hand assets in rental properties. If you purchase a property after 7:30 pm (AEST) on 9 May 2017, you cannot claim depreciation deductions for assets already in the property at the time of purchase. Similarly, if you convert your home into a rental property after 1 July 2017, you are only allowed to claim depreciation deductions on new assets you purchase for the property, not on the existing items.
By understanding these rules and applying them correctly, you can avoid common mistakes and ensure that your tax deductions are accurately claimed. If you have any queries about this or any aspect of the Australian taxation system, contact one of our experts at Symmetry Accounting & Tax.
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