A repair is something that reinstates an investment to its original condition. Technically this means replacing the damaged part of the property with identical materials.
In the case of relatively old properties replacing the damaged materials with identical ones may be impossible in view of changes in technology and that original materials may no longer be available. However, it is accepted that replacing the original materials with a modern equivalent material is acceptable providing it does not ‘improve’ the property.
An example of a repair could be replacement of rotting timber in a property with patented cladding which is a modern-day equivalent. Oddly enough the removal of a worn carpet and the cost of polishing the existing underlying floorboards in a rental property can qualify as a repair.
A capital improvement is where the work on the property is more than just a replacement of the damaged materials. Usually, the property will be modified so that it is improved, it is more ‘efficient’ or the value of the property has increased because of the work done.
A repair involves the restoration of a thing to a condition it had previously without any change to its original character. What is significant with a repair is the restoration of the function of the property rather than the reinstatement of the original materials and appearance. The repair of any investment involves restoring the item by its replacement or renewal of a damaged or worn out part but not the reconstruction of the entire thing.
Making the distinction
There are a number of factors to be considered which assist in deciding whether the work undertaken is considered a repair or a capital improvement. These include asking the following questions:
Has the work undertaken improved the property?
Has the work resulted in greater ‘efficiency’ to the function of the property?
Is there is an increase in the value of the asset?
Repairs to a property that are required at the time it is acquired are treated as capital expenditure. Because the property may have been in a state of disrepair at the time it was acquired, any costs incurred to repair any defects that existed at that time are capital improvements and not repairs.
SMSFs that contemplate the purchase of a property via a limited recourse borrowing arrangement should ensure it does not require ‘initial repairs’ to allow it to be leased to tenants, otherwise it may not satisfy the amended legislation that commenced from July last year.
Direct ownership of the property by the fund means that it can be improved as desired by the fund trustees. Any improvements would depend on the trustee’s intention and the potential those improvements have to return rental income or capital gains. In certain circumstances the improvements can be quite substantial providing they are within the superannuation rules.
Before going ahead with a limited recourse borrowing arrangement the trustees of a self managed superannuation fund should work out what they are going to do with the property; and whether it requires any initial repairs, or will require capital improvements in the near future to continue to enable the property to be leased.
If capital improvements are required now or in the future it may be better for the property to be purchased directly by the superannuation fund, if it can be afforded, or consider other alternatives after seeking the advice of an accountant or adviser who has specialist knowledge in self-managed superannuation funds.