“Broadly, a repair restores something to its original condition. In contrast, an improvement enhances or extends an asset’s useful life,” Butler said.

“Further, a repair is deductible whereas an improvement may add to the cost base of the asset for capital gains tax (CGT) purposes. Deciding between what is a repair versus what is an improvement can prove tricky and requires an understanding of the tax rules and prior case law and tribunal decisions otherwise significant penalties can be imposed for incorrectly classifying these outgoings.”

He continued that repairs and maintenance restore the efficiency, form or function of the asset without altering its original character and costs can generally be claimed as an immediate tax deduction in the financial year they are incurred.

“Examples of repairs and maintenance include fixing a broken window or repairing a leaking roof and a repair can only be claimed to the extent the asset is used to produce assessable income.”

“Moreover, it should be noted that initial repairs — those aimed at fixing pre-existing damage or defects that were present at the time of purchase whether or not known to the buyer — are classified as capital expenses and are not deductible.”

It is important to consider whether a repair that is needed shortly after the purchase of a property is an initial repair, as that cost is generally added to the cost base of the asset for CGT purposes.

“Invariably, when an investment property is purchased to rent to derive assessable income, there are a range of repairs to undertake to make the property in sound order and condition for it to be available and suitable for rent,” Butler said.

Any works or alterations that improve a property beyond its original state and condition are generally treated as capital works or improvements.

“According to TR 97/23, an improvement provides a greater efficiency of function in the asset — usually in some existing function. This might involve replacing an existing workable awning for aesthetic purposes or replacing a broken-down water heater with a better quality and more efficient water heater that has numerous advantages over the prior unit,” Butler said.

“Improvements are generally not deductible, but the costs might be able to be claimed over the life of the asset via depreciation deductions under Division 40 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) if the asset constitutes plant or equipment used to derive rent.”

An improvement may need to be added to the cost base of the asset for CGT purposes and written off over a period.

“Division 43 ‘capital works’ deductions can provide a deduction for building and structural improvements that can be written off, typically at 2.5 per cent per annum, over the ownership period.”

“Additionally, a person who disposes of capital works to another person is required to provide a notice under s 262A(4AJA) of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) about the transferor’s capital works that allows the transferee to work out how their Division 43 of the ITAA 1997 claim will apply to them.”

Furthermore, he noted, where a taxpayer is unable to get this capital works information, such as if a landlord cannot obtain from a departing tenant who has made fit-out improvements to a property, they can engage a quantity surveyor to calculate the Division 43 remaining capital works amount.

When it comes to depreciation, Butler said Division 40 of the Income Tax Assessment Act 1997 contains the uniform capital allowance system rules or depreciation deduction rules.

“Depreciation deductions are available for most depreciating assets used in the production of assessable income, including plant and equipment. Broadly speaking, Div 40 provides a deduction for the decline in value of depreciating assets based on the effective life of the relevant plant and equipment.”

“However, from 1 July 2017, a significant change occurred – a depreciation deduction is reduced/denied where the asset is used to derive rental income from the use of residential premises to provide residential accommodation, but not in the course of carrying on a business, and the asset was a second-hand depreciating asset.”

He added that this change only impacted residential premises and did not impact claims for depreciation on plant and equipment for business or commercial premises. This means an SMSF purchasing an office or warehouse can still claim depreciation in respect of the remaining written-down value of any plant and equipment that is acquired as part of the acquisition of that property.

Finally, regarding exempt current pension income, Butler noted that a deduction in respect of a rental property is only deductible to the extent that the taxpayer derives assessable income.

“Therefore, if an SMSF is 50 per cent in accumulation mode and 50 per cent in retirement or pension phase, the fund will generally only be entitled to claim 50 per cent of the amount as a tax deduction under the unsegregated pension method in s 295-390 of the ITAA 1997.”

“This is because, in this example, the fund is only deriving assessable income to the extent of 50 per cent and the fund is also deriving exempt income of 50 per cent.”

He said the overall tax efficiency of a rental property in an SMSF will depend on whether the fund is in pension mode.

“A greater tax benefit is obtained from a deduction while the fund is in accumulation mode, as the tax saved is typically 15 per cent in relation to each $1. However, the overall tax efficiency of holding an investment property in an SMSF may be enhanced if the fund is in pension phase, especially if a significant net capital gain is likely to occur in connection with the disposal of the property,” he said.

“It should also be noted that if the property is negatively geared, where the deductible expenses exceed the rental income, you should seek advice on whether it is appropriate to continue a pension. Broadly, exempt income reduces a loss for tax purposes, and since a pension results in exempt income, a tax loss (on revenue account) would be reduced by the amount of exempt income under Div 36 of the ITAA 1997.”