Repairs vs capital improvements: how rental property work is taxed

Every dollar spent fixing, replacing or upgrading a residential rental lands in one of three tax treatments, and the difference is mostly timing. Genuine repairs and maintenance are deductible in full in the year incurred, under section 25-10 of the ITAA 1997. Improvements and structural work are capital works deductions under Division 43, generally spread at 2.5% a year over 40 years. New plant and equipment — carpet, curtains, appliances — are depreciating assets claimed as decline in value under Division 40. The same renovation invoice can contain all three, which is why classification is the first question on any rental property job.

The ATO’s test for a repair is that the work remedies defects in, damage to or deterioration of the property, and relates directly to wear and tear or other damage that occurred while the property was being rented out. Its published examples of immediately deductible repairs are telling: replacing a cracked pane of glass in a window, replacing part of the gutter, fixing or replacing part of a fence, and repairing electrical appliances or machinery. The recurring word is “part” — restoring a portion of something, not replacing the whole.

Maintenance is work that prevents deterioration or fixes deterioration that has already happened, generally keeping the property in a tenantable condition. Repainting faded or damaged walls, oiling a deck, cleaning a swimming pool and maintaining plumbing are the ATO’s examples — all deductible in the income year the expense is incurred.

The property side of the test matters as much as the work itself: to deduct repairs and maintenance, the property must continue to be rented on an ongoing basis or remain genuinely available for rent on commercial terms. Short unoccupied periods between tenants are acceptable.

• Your own labour is not deductible. An owner who does the repainting personally can claim the cost of the materials, but not a notional wage for the hours — the ATO’s “Sanjay” example.
• Repairs after the tenants have gone can still qualify, provided the need for the repairs relates to the period the property was producing income, and the property was income-producing at some point during the year the expense was incurred.

Taxation Ruling TR 97/23 draws the line. Work is a repair if it restores the efficiency of function of the property without changing its character. A minor and incidental degree of improvement can still be a repair, but work amounting to a substantial improvement, addition or alteration is not — and is not deductible under section 25-10. The ATO describes an improvement as anything that makes part of the property better, more valuable or more desirable, provides something new, or furthers the property’s income-producing ability or expected life; remodelling a bathroom and adding a pergola are its examples.

The second trap is the “entirety” doctrine. A repair is restoration by renewal or replacement of subsidiary parts of a whole; renewing or reconstructing something separately identifiable as a principal item of capital equipment is not a repair at all (TR 97/23, drawing on Lindsay v FC of T (1960) 106 CLR 377). That is why the ATO treats replacing an entire toilet in a property rented for ten years as capital works, and why its “Janet” example treats completely replacing kitchen cupboards as capital even though the new fittings match the originals in size, design, quality and layout. Like-for-like does not rescue a whole-item replacement.

Where repairs and improvements happen in the same job, a deduction is available for the repair component only if its cost can be separated from the cost of the improvements — the ATO recommends asking builders and tradespeople for an itemised invoice. In its “Caitlin” example, painting deteriorated internal walls was deductible as a repair while rendering and painting the external walls was a capital works deduction, precisely because the itemised invoice split the two costs.

An initial repair rectifies damage, defects or deterioration that existed at the time you acquired the property. Initial repairs are capital and cannot be claimed as an immediate deduction — and TR 97/23 is blunt about the two arguments investors usually reach for: it is immaterial whether you were aware of the property’s condition at purchase, and immaterial whether the purchase price reflected the need for repairs. Equally, a repair is not an “initial repair” simply because it is the first repair after acquisition — what matters is when the damage or deterioration arose, not where the job sits in your sequence of works.

How an initial repair is claimed depends on what was fixed. Initial repairs to structures such as a building or fence can generally be claimed as capital works deductions over 40 years. Initial repairs to depreciating assets cannot be claimed as a deduction at all — although the decline in value of a brand-new replacement asset is generally deductible. Either way the cost is not lost: initial repair costs form part of the CGT cost base, reduced by any capital works amounts claimed or claimable.

Capital works covers building costs, structural improvements, alterations and extensions — the ATO’s examples include alterations to a building, major renovations to a room, adding a fence, building extensions such as garages and patios, and structural improvements such as a driveway or retaining wall. Deductions cannot exceed the construction expenses, can only start once construction is fully completed, and for residential rental property the building must have been built after 17 July 1985 and be rented or genuinely available for rent. Assets fixed to, or otherwise part of, the building or a structural improvement are generally construction expenses claimable only as capital works — and preliminary costs such as architect fees, engineering fees, surveying fees, foundation excavation and building permits form part of construction expenditure too.

In practice, most residential rentals fall in the 2.5% band — construction commenced on or after 16 September 1987 — so treat 2.5% over 40 years as the working assumption. One related rule worth knowing: where renovations are substantial (all or substantially all of the building removed or replaced — foundations, external and supporting walls, floors, roof or staircases — directly affecting most rooms), then apart from replacing depreciating assets, the cost of all the renovations is deductible as capital works, and replacement depreciating assets can be claimed as decline in value only if acquired as new assets.

• To claim, you must know the type of construction, the dates construction commenced and was completed, the construction cost, who carried out the work, and the income-producing periods.
• The purchase price, insured cost and replacement cost cannot be used as the construction cost.
• If actual construction costs cannot be determined, the ATO accepts an estimate from a quantity surveyor or other independent qualified person — and the fee for obtaining the estimate is deductible in the year it is paid. See our guide to depreciation schedules for how these reports work.
• Owner-builders cannot include the value of their own labour or a notional profit margin in construction costs.

Capital works expenses form part of the CGT cost base, and capital works deductions you have claimed (or could have claimed) must be taken into account — reducing the cost base — when a capital gain or loss is worked out on sale. Our CGT records checklist for property investors covers what to keep so this reconciliation is possible years later.

Depreciating assets are items of plant that do not form part of the premises’ structure — usually separately identifiable, unlikely to be permanent, and expected to be replaced within a relatively short period, with all factors considered together. The ATO’s examples of assets costing more than $300 include floating timber flooring, carpet, curtains, appliances such as a washing machine or fridge, and furniture. Under Division 40, owners deduct each asset’s decline in value over its effective life, using either the Commissioner’s determined effective life or their own reasonable estimate. This guide covers only the classification boundary — for how a full schedule is prepared and used, see depreciation schedules explained.

• $300 or less — immediate deduction. Claimable in full in the income year the asset is first used for a taxable purpose, but not if the asset is part of a set that together costs more than $300 — the ATO’s example is four dining chairs at $250 each, which cannot be treated as separate assets.
• Over $300 — depreciate. Decline in value is worked out under the diminishing value method (cost × days held ÷ 365 × 200% ÷ effective life) or the prime cost method (cost × days held ÷ 365 × 100% ÷ effective life). In the ATO’s 2025-26 “Laura” example, a $1,500 asset with a five-year effective life gives a $600 first-year deduction under diminishing value, or $300 under prime cost.
• Under $1,000 — pooling available. Depreciating assets valued at less than $1,000 can be grouped in a low-value pool and depreciated together rather than individually.

Everything above still governs what a piece of work is. The Treasury Laws Amendment (Tax Reform No. 1) Act 2026 (No. 49 of 2026), which received Royal Assent on 26 June 2026 and is law, does not touch section 25-10, TR 97/23, the entirety doctrine, Division 43 or Division 40. What its Schedule 2 changes — from the 2027-28 income year, not the year now under way — is when a correctly classified residential-property deduction can actually be used.

Schedule 2 inserts sections 26-155 and 26-160 of the ITAA 1997. Where deductions relating to residential dwellings used or held for residential accommodation exceed the assessable income from them for an income year, the excess is not deductible in that year. It is quarantined: it may be applied against specified residential capital gains, and any remainder is carried forward under the enacted rules. The deductions are deferred, not lost — the only permanent forfeiture is on bankruptcy or an equivalent release from debt (s 26-155(8)–(9)). Schedule 2 commenced on 27 June 2026, but it applies to the 2027-28 income year and later.

• Grandfathering runs off “last acquired”, not “owned”. Amounts are disregarded to the extent they relate to an ownership interest in a residential dwelling last acquired before 7.30 pm, by legal time in the Australian Capital Territory, on 12 May 2026 (s 26-155(2)(a)). For a dwelling acquired under a contract, you hold the ownership interest from the contract date, not settlement (s 26-155(3)).
• Entity carve-outs. Complying superannuation entities and widely held unit trusts are carved out of the rule entirely (s 26-155(4)). Amounts relating to providing a fringe benefit are also disregarded (s 26-155(5)).
• Not every property is a “residential dwelling”. Caravans, mobile and tiny homes, hotels, motels, inns, hostels, boarding houses and other listed dwellings sit outside the rule (s 26-160(1)).
• The “new residential dwelling” exception cannot presently operate. The legislative instrument that would define a new residential dwelling for s 26-160(4) had not been made as at 13 July 2026, and no determination had been made under s 26-155(2)(c) either. We do not describe requirements that do not yet exist.

Two things Schedule 2 does not do: it does not abolish deductions for residential property, and it does not cause them to be lost. It changes the year in which an excess can be used. Whether it affects a particular property turns on when the ownership interest was last acquired, the entity that holds it and the kind of dwelling it is — a question for your own facts, not a general rule. The rule itself, its exceptions and the instrument that has not yet been made are set out in our companion resource on negative gearing from 2027-28.

Rental records must be kept for five years — depending on the situation, five years from the date the return is lodged, from the last claim for an asset’s decline in value, from the date it is certain no CGT event can occur, or from the date any dispute with the ATO is resolved. Because capital works and initial repair costs live on in the cost base until sale, the practical horizon is often much longer — our CGT records checklist sets out a filing structure that survives a decade of ownership.