Tax Treatment: Repairs and Capital Works
1 July 2019 saw the beginning of a new financial year – something which inevitably triggers the preparation and lodging of tax returns.
While the calculation of deductions under most tax returns will be relatively straight forward, problems can arise when people have income and deductions connected with rental properties. That is relevant because in June 2019, the ATO advised that it will be paying close attention to people who may have inaccurate interest claims, and who are attempting to claim capital works expenditure as repairs and maintenance.
The distinction between capital works and repairs is something that interests property lawyers and accountants. For property lawyers, it is usually important for the preparation and recovery of outgoings from tenants. Expenditure that is capital in nature usually relates to structural improvements. Under the covenant to repair, these are not usually recoverable from tenants as outgoings.
For accountants, the determination of whether something is of a capital nature or revenue is relevant because revenue expenditure is immediately deductible. Capital expenditure is not.
Under the Income Tax Assessment Act 1997 (Cth) and subject to any apportionment rules that apply depending on the extent to which the asset is used to produce income, expenditure on repairs and maintenance is something that is directly attributable to the generation of income. This means it will be immediately claimable in its entirety for the relevant financial year. Expenditure on capital items will not be immediately claimable but may be depreciated over a number of years depending on the effective life and value of the asset.
Whether something is a repair or not is often a question of degree. The word ‘repair’ is to be taken in its natural and ordinary meaning. In essence, it generally involves the acquisition of items or completion of subsidiary works that are necessary or needed for the continued generation of rental income, having regard to the condition of the property at the commencement of the lease.
For deduction purposes, although the focus is on ‘like for like’ (meaning things like the age and character of the building, cost, nature and availability of materials will be relevant when determining whether an immediate deduction is available), the covenant to repair also recognises that it is not always practical to replace dilapidated items with something that is equally dilapidated or a similar quality. Some renewal may be inevitable providing the works are necessary and cannot be done without making some improvements.
In many cases, it is not practical or possible to rectify something without improving it. Building industry practices, technology and Australian Standards frequently change. Providing the rectification works are reasonable, necessary (having regard to what was available at the beginning of the lease) and not capital in nature, it should be treated by the Australian Taxation Office (ATO) as revenue expenditure.
Expenditure that is revenue in nature is to be compared to expenditure of a capital nature (i.e. capital expenditure). Capital expenditure generally involves the acquisition of assets, or the completion of works on items that are to be used for income producing purposes over longer periods (e.g. multiple tax years). For deduction purposes, it also includes initial repairs which is any repair that is performed following the acquisition of the property, but before it is rented out or is actively made available for rent.
If the expenditure is of a capital nature, it is to be depreciated over the effective life of the asset by using the diminishing value method or the prime cost method. In short, this means the entirety of the expenditure will not be immediately deductible. Landlords should normally obtain a depreciation report or schedule from a qualified professional to document the expenditure.
Exceptions do apply. One relates to low-cost assets that were $300 or less which are immediately claimable in their entirety. Another relates to items of expenditure that cost between $300 and $1000. These items may be allocated to the low value asset pool which enables people to claim up to 35% of the expenditure in any given tax year until it is written off.
In the context of leasing transactions, the main expenditure items that will be considered to be of a capital nature are:
- any works that are structural in nature (works related to the structure of the building like the foundations, frame and in some cases the roof and fire equipment);
- initial repairs;
- any improvement to the property that, while desirable, was not reasonably necessary having regard to the condition of the property at the start of the lease; or
- anything else that cannot be treated as a repair.
If you have any questions or would like more information please call us today.