Rental Property Deductions: Repairs vs Capital Improvements Explained

Rental Property Deductions: Repairs vs Capital Improvements Explained

A rental property generates two kinds of deduction: expenses claimed in full the year you pay them, and costs spread over several years through depreciation. Confusing the two, especially a repair with a capital improvement, is one of the most common errors in rental property tax returns, and one the Australian Taxation Office reviews closely. Here is what is actually claimable, and where the line sits.

What You Can Claim in the Year You Pay It

Subject to the usual apportionment for any private use, immediate deductions generally include:

• Interest on the loan used to buy or improve the property (the interest only, not loan principal)
• Council rates, water rates and land tax
• Landlord and building insurance premiums
• Property management and letting fees, and advertising for tenants
• Cleaning, gardening and pest control
• Body corporate levies covering day-to-day administration and maintenance
• Genuine repairs and maintenance

Repair or Improvement? The Distinction That Trips Up Most Investors

The ATO's test turns on what the work actually does. A repair remedies or prevents defects, damage or deterioration caused by renting the property out, and restores something to its original condition and function. It is deductible in full in the year you pay for it. An improvement makes the property, or an item in it, better, more valuable, more desirable, or changes its character. That is capital expenditure: not deductible immediately, and instead written off over time as part of a depreciation claim.

Replacing a storm-damaged section of an existing timber fence with the same style of fencing is a repair. Replacing the whole fence with a higher-grade colorbond fence is an improvement. Repainting a wall in similar condition is maintenance. Replacing a laminate kitchen benchtop with stone, or adding a carport where none existed, is an improvement.

A separate trap is the "initial repair": work fixing damage or wear that already existed when you bought the property, done before you first rent it out, is capital expenditure even though it looks like a repair, because it prepares the property to earn income rather than maintains income already being earned.

Where repairs and improvements happen in the same job, you can only claim the repair portion immediately, and only if it is separately identifiable. Get an itemised invoice from the tradesperson, otherwise the ATO can treat the whole cost as capital. See our article on why managing agent statements don't always get this right.

Depreciation: Two Divisions, Two Different Rules

Capital expenditure is not lost, it is generally recovered under Division 40 or Division 43 of the Income Tax Assessment Act 1997, each with its own rules.

Division 43: Capital Works

Capital works covers the building's structure and fixed items such as brickwork, tiling and built-in cabinetry. For residential construction that commenced after 15 September 1987, the deduction is generally 2.5% of construction cost per year for up to 40 years. This applies regardless of who built the property or when you bought it, provided you can establish the original construction cost.

Division 40: Plant and Equipment, and the 2017 Second-Hand Rule

Plant and equipment, removable or mechanical items such as carpets, blinds, hot water systems, ovens and air conditioners, is depreciated individually over each asset's effective life. Since 1 July 2017 (contracts exchanged after 7:30pm AEST on 9 May 2017), section 40-27 of the ITAA 1997, inserted by the Treasury Laws Amendment (Housing Tax Integrity) Act 2017, stops most investors depreciating plant and equipment already installed when they bought a residential property second-hand. It does not apply if you carry on a business of letting residential property, or you are an excluded entity such as a company, large super fund or public unit trust. It only catches assets already in the property at settlement: a new item you buy and install yourself afterwards remains fully depreciable, and Division 43 claims are unaffected.

Why a Quantity Surveyor's Schedule Matters

Because the two divisions use different rates, methods and, since 2017, different eligibility rules, most investors engage a quantity surveyor to prepare a depreciation schedule. Under Taxation Ruling TR 97/25, a quantity surveyor is recognised as appropriately qualified to estimate original construction costs where these are not otherwise known, which is common with an established property. A good schedule splits every asset correctly between the two divisions, and flags which items fall inside the second-hand restriction.

Getting this right is one of the ATO's most closely reviewed areas of rental property tax, and mistakes run both ways: understating deductions costs you money, overstating them invites a review. FTC's property investor tax specialists can check your expenses and depreciation schedule against the current rules before you lodge.

Disclaimer: This article contains general information only and does not constitute financial, legal or tax advice. It has been prepared without regard to your objectives, financial situation or needs. Tax and superannuation laws change frequently, and the information in this article may not reflect the current law or may become inaccurate over time. Before acting on anything in this article, you should consider its appropriateness to your circumstances and seek advice from a registered tax agent or qualified adviser.