Sometimes the apparent simplicity of something can be deceptive, and taxation is often an example of this. Over a barbecue or in the pub, people who have investment properties routinely share hot tips about their property investments and tax deductions, without any qualification.
“Of course the costs of ripping out that entire staircase in the property you just purchased and putting a new one in due to termite damage is tax deductible – it is an investment property, isn’t it?”
Unfortunately, this is not always the case.
Not for the lack of trying, tax accountants often find themselves in a position where they don’t always have the opportunity to explain every tax deduction claimed in a tax return to their clients, due to reasons of practicality – ie there is a cost associated with the time required to go through the tax return on a line-by-line basis, assuming that the client has the patience or interest to sit through the tax lecture!
In this article, we'll look at two common misconceptions about tax deductions related to investment properties: those associated with investment seminars and property repairs.
• Investment seminars
There are a number of investment seminar products on the market, which are often targeted at first-time investors who hope to improve their financial literacy and investment knowledge. A lot of these seminars are specifically related to property investments, when the organisers may go as far as to provide post-seminar services to assist participants in finding and buying their first investment properties.
There are also other more advanced-level seminars for people who already own investment properties but wish to refine their investment strategies and maximise the income from their existing investments.
"If you incur costs on an investment seminar before you have purchased any investment ... the costs may be treated as having been incurred too soon"
Many people automatically assume that the costs of these seminars are categorically tax deductible because they are related to income-producing activities. However, unless you are carrying on a business, the tax law only allows you to claim a tax deduction if you incur costs “in the course of producing assessable income”, provided that they are not capital or private in nature.
Therefore, if you incur costs on an investment seminar before you have purchased any investment, or if the seminar is related to strategies and structuring advice to help you start your investment portfolio, the costs will be treated as having been incurred too soon, ie before you are in the course of producing assessable income from your investments. In this case, they will not be tax deductible.
Even if you already own existing investments, if the seminar is related to how you could source new investment properties or to general strategies on wealth creation, the costs of the seminar will likely be considered capital in nature and not therefore tax deductible.
On the other hand, if you have already acquired investments and you are attending a seminar that provides information on how you could manage and maximise income from your existing investment portfolio, the costs of the seminar will be treated as having been incurred in the course of producing income and are therefore tax deductible.
To add to the complexity of the issue, it is common for many seminars to have mixed content. For instance, a part of the seminar may be related to how you could maximise your financial returns from your existing investment properties while another part may be related to future wealth creation strategies and skills on how you could source further investment properties.
In these cases, you will need to apportion the costs of the seminar to ensure that you are only claiming a tax deduction on the portion of the costs that relate specifically to how you could maximise your financial returns from your existing investments.
An exception to the above is a cost that relates to the management of your tax affairs, for example information on how to minimise your tax liabilities through structuring. The costs related to the part of the seminar on tax affairs management are generally tax deductible.
• Repairs and improvements
This area is one of the most common ‘audit hotspots’ that attract the attention of the ATO, so getting it right could save you a whole lot of heartache in the future. These are a few of the most confusing points:
Initial repair
Generally, if you spend money repairing an investment property or a depreciating asset in the property that you recently acquired, the repair costs are treated as capital expenditure and are not immediately tax deductible. This is because the thing needing repair was not damaged or worn down during the course of you deriving income from the property, ie the wear and tear was caused during the period when the property was owned by the previous owner.
General repair
If you incur expenditure to restore something to the original condition it was in when you acquired or constructed it, and the repair is not an initial repair, the repair costs will be tax deductible up front. This is provided that it is not considered an ‘improvement’ rather than a repair, under one of the following categories:
- Costs related to work that goes beyond restoring something to its original condition and improves the thing’s functional efficiency (except where you are using the modern equivalent of a material that needs replacement as part of the repair)
- Costs incurred to replace all or a major part of the structure of the property may be seen as a ‘replacement of an entirety’ and therefore not a repair. However, it is not always clear where the dividing line is between a repair and the replacement of an entirety, and this therefore needs to be determined on a case-by-case basis.
If the costs are attributable to an improvement, they may or may not be eligible for the depreciation or capital works deduction, as discussed in detail in the next section. (See box at right for two ATO examples that provide some guidance on when a repair is differentiated from an improvement.)
ATO Example 1
Ken-the-Shopfitter runs a factory in a building in which the wooden floor needs repairing. The options are either to repair the old floor or to replace it with an entirely new one of steel and concrete.
Ken decides to adopt the second option because it will save future repairs and because it has distinct advantages over the old wooden floor. By choosing the second option, Ken cannot claim a deduction as if he had simply repaired the wooden floor. His actual expenditure being capital, none of it is allowable as a repair. It can be claimed as a capital expenditure item, as outlined further in this article.
ATO Example 2
Mary Fabrica owns a factory in which the bitumen floor laid on a gravel base needs repairing.
She replaces it with a new floor consisting of an underlay of concrete topped with granolith
(a paving stone of crushed granite and cement). The new floor, from a functional efficiency (rather than an appearance) point of view, is not superior in quality to the old floor. The new floor performs precisely the same function as the old and is no more satisfactory. In fact, the new floor is more expensive to repair than the old. Because the new floor is not a substantial improvement, it is a repair and its cost is deductible.
As illustrated by these examples, it can sometimes be a hair-splitting exercise to correctly characterise whether expenditure relates to a repair, depreciating asset, or capital works. Given the potential downside of getting such characterisation wrong and incurring the ire of the ATO, it is strongly advised that you obtain proper professional advice to steer you through the tax maze if your situation is less than ‘vanilla’.
• Capital expenditure
Some property repairs and upgrades actually fall under the category of capital expenditure and therefore cannot be claimed as a deduction at tax time.
Generally speaking, the tax treatment of a capital expenditure incurred on the physical premises of an investment property will depend on the nature of the thing acquired, which can most commonly be classified as one of the following:
• expenditure incurred to acquire a depreciating asset
• expenditure incurred on capital works
This applies irrespective of whether it is related to initial repairs or capital expenditure that you incur during the ownership of the property.
As the exception rather than the rule, a capital expenditure may also fall into a third category, which may or may not be included in the cost base of the property, but this is beyond the scope of this article.
The capital expenditure item may relate to a functional unit or item of ‘plant’ that is not permanently attached, for example a stove that is not attached to the building, or an air-conditioning system that is attached to the building but is also an item of plant. In this case, the expenditure can be claimed as a depreciation deduction over the effective life of the unit, under either the prime cost or diminishing value method.
On the other hand, the expenditure may relate to something that is permanently affixed to land and buildings and is not an item of plant, for example an extension to an existing building, or a structural improvement. In this case, the costs will be eligible for the capital works deduction, which is generally claimed at 2.5% of the ‘construction expenditure’ on a straight-line basis.
In limited cases, the capital works deduction rate may increase to 4%, for example if the property is used as a motel that has at least 10 rooms.
It is important to note that, unlike depreciating assets, if you did not pay for the construction of the capital works yourself, the amount you can claim is based on the original construction cost and not what you paid the previous owner to acquire the capital works.
While it is generally straightforward to determine the cost of a depreciating asset for the purpose of claiming a depreciation deduction, which is normally what you paid for it (which includes the costs of bringing the asset to its present condition and location), working out the construction expenditure for the purpose of claiming the capital works deduction may not always be so easy.
The term ‘construction expenditure’ generally refers to the actual costs of constructing a building or structural improvement that is permanently attached to land. If you engage a builder and other contractors (for example architect, engineers, tradespeople, etc.) for construction on your land, the construction expenditure is the amount you pay the builder and contractors, including the part of the costs that represents their profit margins. However, if you buy a property from a speculative builder, you are not allowed to claim the component of your costs paid to them that represents their profit margin.
Similarly, if you perform the construction work yourself, the value of your contribution cannot form part of the construction expenditure; neither are you allowed to add a notional profit margin to the expenditure for capital works deduction purposes.
Further, not all expenditure qualifies as construction expenditure that is eligible for the capital works deduction. Qualifying construction expenditure includes costs associated with foundation excavations, retaining walls, fences, and in-ground swimming pools. On the other hand, costs associated with land clearing, landscaping, and permanent earthworks that can be economically maintained but are not integral to the installation or construction of a structure are not considered construction expenditure for the purpose of the capital works deduction.
Since it may be less than straightforward to determine the correct amount of construction expenditure for the capital works deduction claim, it is a requirement of the law that the seller of a property that has had capital works expenditure incurred on it must provide a report to the purchaser with the details of the costs of the capital works. However, if the purchaser has not received such a report from the vendor, the purchaser can obtain a depreciation report or building cost estimate from a qualified quantity surveyor to determine the construction expenditure for the purpose of claiming the capital works deduction.
