Repairs vs Improvements #2 April 2023
Repairs vs Improvements
In the 20 plus years we have been doing Depreciation Schedules, questions about Repairs vs Improvements would outnumber all others put together.
And that’s not too surprising. The line between Repairs and Improvements is a bit blurry, so with tax season around the corner, we thought it timely that we focus on it.
Questions about all sorts of things come to us from property investors and accountants alike. Is there something you would like us to clear up? Just let us know and we’ll cover it in an upcoming ‘Something You Didn’t Know About Depreciation’.
This month, it’s Repairs vs Improvements. We know clients are always keen to claim work as Repairs because that means a 100% immediate tax deduction vs a worst case scenario of 2.5% per year in depreciation. It’s your job to temper their enthusiasm.
Key points for Repairs vs Improvements
- It’s important you understand the difference between Repairs and Improvements to avoid your client overclaiming and incurring a penalty.
- The ATO’s definition of a Repair is ” to restore something to the condition it was in when your client started to rent out the property”.
- An Initial Repair is when a client buys an investment property and does work on it prior to renting out the property. These are treated as Improvements.
- Replacing a whole Asset is not a Repair. It’s an Improvement.
- There are always scenarios that are not clear. Seek Early Engagement from the ATO for guidance.
Repairs vs Improvements. Why is it important to get it right?
This one is pretty obvious. If non eligible work is expensed as Repairs, rather than being depreciated, it means the taxpayer is over claiming – possibly by thousands of dollars. At some point this could come to light and everything will need to be untangled and penalties possibly imposed by the ATO. So it’s important to get it right from the start.
What is the ATO’s definition of a Repair?
This is what trips clients up. They think that if they buy a house and get the keys and decide it needs an internal paint before they try and get a tenant, they should be able to claim that paint job as Repairs and Maintenance.
Nope. The ATO is very clear. A Repair in their eyes means restoring something to the condition it was in when YOUR CLIENT started to rent out the property. In painting that property, the client has improved it, and not repaired it. The work needs to be depreciated, not claimed as an immediate deduction.
Logically, the longer a client has been renting out their investment property, the greater the scope there is for claiming work as Repairs. But the question you still need to ask your client is whether the work they did related to a problem that existed before THEY started to rent out the property.
How are Initial Repairs different from run of the mill repairs?
The term ‘Initial Repairs’ is one the ATO use. It describes exactly the previous scenario i.e. a client buys an investment property and does work on it prior to renting out the property. Initial Repairs are treated as Improvements and you would likely depreciate them as Capital Works i.e. 2.5%.
What other things might a client do to an investment property immediately after purchase and think it’s a Repair?
Fixing a damaged kitchen benchtop, replacing peeling cupboard doors, some plasterwork to hide a hole, new glass in a broken window, replacement gutters and a downpipe. All these things if done to a property before the client rents it out are not Repairs, they are Improvements.
‘Okay’, say some clients. ‘What if I rent the property out for 6 months and then do that stuff? Can we call it repairs then?’ You know the answer to that – no dice. And that’s because the problems already existed when they started to rent out the property.
Replacing a whole Asset is not a repair…
Asset is another term for Plant and Equipment. Think stoves, air con units, hot water systems, floor coverings etc.
Let’s say a client has been renting out an investment property for a year or so and an element on a cooktop fails…
They have it replaced, and that’s a Repair – immediate claim. No argument there.
Then a month later, another element fails. This time your client opts to replace the whole cooktop rather than keep fixing it. When they elect to install a new cooktop and replace entirely the old one, they need to depreciate that new cooktop. They cannot claim the replacement cost as a Repair.
The same applies to hot water units, air cons, and any other Assets in an investment property. If an entire item is replaced, even though it might be unrepairable, it needs to be depreciated.
The blurry line between bathroom Repairs vs Improvements
This is a scenario we hear from property investors at least once a month and it’s a useful one for demonstration purposes.
Leaking Bathroom – Repair or Improvement?
Typically, a client has been renting out an older property for several years and has been told that the waterproofing in the bathroom has recently failed and is causing water to penetrate other rooms.
So a plumber investigates and the only way to fix it is to take all the tiles off the shower walls and floor, repair the membrane, and retile.
The problem is that the new shower will look a bit odd in an older bathroom, so the client logically decides to do a complete bathroom renovation. That’s where things get tricky because they are not just carrying out repairs, they are also improving the whole bathroom.
Ideally, the client would get the contractor to apportion the invoice to ‘Repairs’ and ‘Improvements’, but this is difficult after the fact. So the client will need to think about how much of that $15,000 bathroom reno they think can legitimately be claimed as Repairs and how much needs to be depreciated as Capital Works i.e. 2.5%.
Replacing a damaged deck – Repair or Improvement?
Work done to decks and verandahs in an investment property can have similar blurred lines. Timber decks in areas that get a bit of rainfall can develop problems quickly. So a client might have been renting out a property for some years and their agent tells them the timber deck has rotted in a few places and needs to be fixed. A contractor suggests that the whole deck will fail eventually so a better solution would be to replace it all rather than repair bits of it. That puts us in ‘Repair’ vs ‘Improvements’ territory. Again, it would be useful to have an invoice that details what component of the job might be a Repair.
ATO Early Engagement for tricky Repairs and Maintenance scenarios
There are endless scenarios like these and it’s not always clear what to do, even with our more than 20 years of experience in this field. We can only give an opinion, and if there is still some uncertainty, clients may like to apply for ATO Early Engagement. The ATO provides this service free of charge and it is a useful way to get some guidance. It is less formal than a ruling, non-binding, only takes a few weeks, and is, of course, free.
News: More home building companies collapse
You can hardly read the news at the moment without hearing about another collapse of an Australian building company. Most recently, it was Porter Davis Homes Group and Lloyd Group.
With fixed price contracts, inflationary pressures, and supply chain issues increasing the cost of building materials, the resulting surge in the cost of construction has spelled disaster for many Australian companies.
For property investors, we’ve been hearing more and more cases where clients have had to engage a second builder to complete the construction of their new home. If this happens to your client, make sure they keep a record of all costs from both builders: at the end of the day, both costs will count towards the total construction cost in determining their depreciation allowance.
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