Why is it important to understand the difference between a repair and an improvement to your investment property?
The property investor is often grappling with whether an expense is a repair or an improvement.
This is critical because a repair can be written off immediately whereas an improvement must be written off over a longer period (depreciated).
To attract higher rental incomes, or to improve the value of an investment, many investors chose to renovate their properties.
When undertaking a renovation, these investors will normally both repair and improve with a different tax treatment for each.
How do you make the distinction?
To repair something means to fix defects, including renewing parts.
It does not include a total reconstruction.
A repair is something that is designed to allow the property to continue to exist in its current state.
An improvement provides greater efficiency of function in the property.
It makes the structure more valuable or desirable compared to repair.
Normally the improvement will extend the property’s income-producing ability and significantly enhance its market value.
As a renovator, you should focus on value as opposed to just tax as an improvement should increase the market value and rent which will be compounded over time.
Property investors can claim as a repair item such as painting, replacing part of the gutters, maintaining plumbing, repairing a water leak, replacing a broken kitchen door or a broken window, painting a room or replacing the carpet in a room.
The ATO may also look at frequency and size to determine whether an expense is a renovation i.e. replacing the kitchen one cupboard at a time.
If the investor replaces all the guttering or carpeting, then this is an improvement and must be depreciated.
Different depreciation rates will apply based on useful life and the expenditure will need to be split between plant and equipment (carpet, window coverings, hot water system) or capital works (being the building).
Another question to be addressed is the timing
If a repair is completed before a property is first rented, then the costs will be classified as an improvement because the ATO argues that the purchase price must have taken the disrepair into account.
It is important to get a depreciation schedule when renovating and you must ensure it is broken down into each component of the work to maximise the allowable depreciation.
Note: For properties owned prior to 1 July 2017, a scrapping schedule will allow you to write off any depreciation not yet claimed on plant and equipment.
Since 1 July 2017, the Government has limited plant and equipment depreciation (not building) so it only applies to items paid for by the investor or for new properties.