Rental property deductions the ATO keeps disallowing

Incorrectly reported interest expenses account for 42% of the $1.2 billion tax gap the ATO attributes to rental properties among individuals not in business. In its June 2024 warning to rental property owners, the ATO said most owners are making mistakes despite 86% of them using a registered tax agent. The disallowed claims are the same handful, year after year.

Repairs, maintenance and improvements are three different things

A repair remedies damage or deterioration that occurred while the property was rented out. Maintenance prevents or fixes deterioration. Both are deductible in the year you incur them. The ATO's guidance on repair and maintenance expenses gives the examples: a cracked pane of glass, part of a gutter, part of a fence, repainting walls the tenants damaged.

An improvement is anything that makes part of the property better, more valuable or more desirable, or changes the character of the item worked on. An improvement is capital works. You claim it at 2.5% a year over 40 years, not in the year you paid the invoice.

The test is not what you spent. It is whether you restored a function or upgraded one. Replace a damaged fibro wall with plasterboard and you have restored it — that is a repair, even though the material differs. Replace it with a brick feature wall and you have improved it. Same wall, same tenant damage, different answer.

Then there is the entirety. A toilet, a fence, a set of kitchen cupboards is a separately identifiable item with its own function. Replacing the whole of one is never a repair, however worn the original.

Where a job mixes repairs and improvements, you get the repair deduction only if you can separate the cost. Ask for an itemised invoice on the day.

Initial repairs: the one that catches new owners

Work that rectifies damage, defects or deterioration existing when you bought the property is an initial repair. It is capital. It is not deductible in the year you pay for it, and it makes no difference that you did not know at settlement.

That is the whole rule. There is no discretion in it and no exception for small amounts.

Initial repairs to a building or a structure are generally claimed as capital works over 40 years. Initial repairs to a depreciating asset get no deduction at all. The cost does form part of your capital gains tax cost base when you sell, reduced by every dollar of capital works you claimed or were entitled to claim.

Capital works under Division 43, depreciating assets under Division 40

Two sets of rules, two different outcomes, and the ATO tests both.

Capital works (Division 43) covers the building itself plus structural improvements — extensions, alterations, retaining walls, driveways, fences, kitchen cabinetry. For a residential property the rate turns on when construction started. Construction commencing on or after 16 September 1987 is deductible at 2.5% a year for 40 years. Construction commencing between 18 July 1985 and 15 September 1987 is 4% a year for 25 years. Nothing built before 18 July 1985 qualifies, though structural improvements added later can. The rates and dates are in the ATO's guidance on working out capital works deductions.

You need the construction cost, not the purchase price. Where the actual cost cannot be established, a quantity surveyor's estimate is accepted, and the fee is itself deductible.

Depreciating assets (Division 40) are items that are not part of the structure: the oven, the dishwasher, carpet, blinds, the air conditioner. An asset costing $300 or less is deductible immediately. Above $300 you claim decline in value over its effective life.

The 2017 restriction on second-hand assets

From 1 July 2017, an individual cannot claim decline in value on a second-hand depreciating asset in a residential rental property. Second-hand means the asset was already installed ready for use, or used, by somebody else — which describes almost everything that comes with a property you buy.

The ATO's guidance on second-hand depreciating assets fixes both dates. You can still claim if you bought the asset before 7.30pm on 9 May 2017 and installed it in the rental before 1 July 2017. Otherwise, nothing. The restriction came in through Schedule 2 of the Treasury Laws Amendment (Housing Tax Integrity) Act 2017, headed "Limiting depreciation deductions for assets in residential premises". It does not apply to corporate tax entities, public unit trusts, managed investment trusts, or a business of letting rental properties.

Two consequences owners miss. Move out of your own home and rent it out on or after 1 July 2017 and the assets in it while you lived there are second-hand — nothing for the fridge, the curtains or the carpet. A brand-new asset you buy for the property is still fully depreciable.

A Robina townhouse: what $16,000 of "repairs" is actually worth

An owner buys a townhouse in Robina in August 2023 for $640,000 and rents it out from settlement. Construction was completed in 2005, so capital works run at 2.5%.

In the 2024–25 year he spends $16,000 and books all of it as repairs and maintenance:

• $1,400 repairing a section of fence the tenants damaged
• $12,000 replacing the kitchen cupboards, which had deteriorated
• $2,600 fixing a shower leak that was already there when he bought

Only the fence is a repair. The cupboards are an entirety, so they are capital works. The shower defect predated his ownership, so it is an initial repair — also capital works. Doing the work 18 months later does not change that; what matters is the state of the property at purchase.

His actual first-year deduction:

• Fence repair, immediate: $1,400
• Capital works on $14,600 at 2.5%: $365
• Total: $1,765

Not $16,000. He has reclassified $14,600 to capital works, and after this year's $365 of it, his first-year deduction is short by $14,235. At a 39% marginal rate that is $5,552 of tax in this year alone.

The $14,600 is not lost. It returns at $365 a year for 40 years and reduces his CGT cost base by every dollar claimed. But the cash lands four decades away, and had he claimed the $16,000 and been reviewed, the shortfall would carry interest.

Two more items. A new dishwasher bought for $900 is a depreciating asset he claims over its effective life, because it is new. The fridge that came with the property is second-hand and gets nothing. Splitting that $16,000 correctly is not tax planning, it is bookkeeping at the right level of detail, — the categories rather than the arithmetic are what we check in an accounting and advisory review.

Apportionment: part of the year, or part of the house

You claim expenses to the extent the property was rented or genuinely available for rent. Genuinely available means advertised in a way that gives broad exposure to potential tenants, on terms a tenant would realistically accept. Word of mouth, or a rate well above market, does not.

Apportion on a fair and reasonable basis, normally by time or by area:

• Time-based. (Days used to produce income + days held to produce income) ÷ days you owned it during the year, applied to the expense.
• Area-based. The floor area let out as a proportion of the whole, where you rent out part of a house.

Use the property privately for part of the year and that period comes out, even if it is short. Expenses relating solely to letting — advertising, the agent's commission — are fully deductible and not apportioned.

Interest, redraw and borrowing expenses

Interest is deductible to the extent the borrowed money was applied to producing assessable income. What the loan is secured against is irrelevant; what the money bought is decisive. Borrow $400,000, use $380,000 for the property and $20,000 for a car, and 95% of the interest is deductible — for the life of the loan.

Redraw is where this comes undone. Redraw from an investment loan and spend it on a car, a holiday or school fees and the loan becomes mixed-purpose from that moment. The ATO's guidance on rental interest expenses is blunt about what follows: you cannot repay only the private portion. Every repayment is apportioned across both components for the life of the loan. That is the position in Taxation Ruling TR 2000/2, on interest drawn under line of credit and redraw facilities.

One redraw can therefore affect a loan's deductibility for twenty years, and the record-keeping sits with you, not the bank. How a facility is structured is a lending question rather than a tax one, and our home loans page covers that side of the firm. The deduction itself is settled by where the borrowed money went.

Borrowing expenses are a separate category and routinely forgotten. Loan establishment fees, lender's mortgage insurance, mortgage stamp duty, broker fees and a lender-required valuation are claimed over five years, or the loan term if shorter. Where the total is $100 or less, the ATO's rental borrowing expenses guidance allows it all in the year you incur it. Stamp duty on the transfer of title is not a borrowing expense — it is capital, and goes to the CGT cost base.

What the ATO already knows before you lodge

Owners assume the ATO sees a rental schedule and little else. That stopped being true years ago.

• Rental bonds. Under its rental bond data-matching program, the ATO collects data from every state and territory bond authority, including Queensland's Residential Tenancies Authority, on approximately 2.2 million individuals a year. The fields include the property address, lease dates, rent payable, the bond amount and the landlord's bank account.
• Property management software. The ATO's property management data-matching program protocol covers 2018–19 to 2025–26 and collects data on approximately 2.3 million individuals each financial year, including the income and expense reports your agent produces.
• Landlord insurance. The ATO's landlord insurance data-matching program protocol runs from 2021–22 to 2025–26 and collects data on approximately 1.6 million individuals each financial year: policy dates, premiums, insured values and claim payments.

All of it is obtained under section 353-10 of Schedule 1 to the Taxation Administration Act 1953, a coercive power. Providers do not get to decline.

So the ATO can often see the rent charged, what your agent paid on your behalf and what your insurer paid on a claim, before you lodge. Much of it pre-fills. A claim that does not reconcile is a discrepancy the system finds on its own.

If your rental schedule has been prepared the same way for several years, check the categories rather than the totals. That is the work that sits in taxation and compliance, and it is almost always the categories that are wrong.