Money
Are tax sops enough to make real estate investments appealing?
Summary
Rental yields offer better returns than most other investments because of the tax sops offered by the government.Homebuyers are a distressed lot. Their equated monthly instalments have been ballooning ever since a flurry of rate hikes by the Reserve Bank of India over the last one year. And many of them decided to immediately prepay part of their home loans, even if that meant breaking their fixed deposits and other investments. Take the case of Delhi-based lawyer Prasouk Jain, who saw his home loan interest rate jump from the sanctioned rate of 6.4% to 9.2% in just 15 months on the back of successive repo rate hikes. He, too, made a part-prepayment of the loan to mitigate the impact. He also negotiated with the bank for a lower rate of 8.4%.
Most homebuyers are now scrambling to make more prepayments. Jain, though, decided against it after doing some number crunching. Jain’s residential property earns him a handsome 7.36% rental yield. He claims a 30% deduction on this rental income. Separately, he can also claim the entire interest paid on the home loan as deduction (under section 24b) since the property is let out and is not occupied by him. To be sure, deduction on interest in a self-occupied property is capped at ₹2 lakh.
After claiming both tax deductions, Jain ’s effective interest paid on the loan comes to just 2.9%. “If I put the prepayment amount in a bank fixed deposit (FD), it will earn me 4.5-5%, post tax-return. That’s higher than the effective interest rate I’m paying on the loan due to the tax sops. I’ve decided to not make any further prepayments," he said.
This is the leverage that tax breaks on real estate purchases give property owners. “People who buy property for rental income don’t have to prepay the loan," said Nishant Batra, chief goal planner, Holistic Prime Wealth, and a mutual fund distributor. To be sure, this may not be suitable for all property owners servicing a home loan. “Some people see loans as a leverage, while others see it as an obligation that they need to get rid of. Those considering it an obligation should close the loan as early as they can," Nishant added.
Besides, the benefits of tax breaks on real estate properties are not limited to the decision of whether one should prepay the loan or not. The tax sops offered by the government act as subsidies that considerably bring down the effective interest you pay on the loan taken for property purchase, making real estate an attractive investment for some people (see graphic).
Special treatment
Real estate is the only asset class that enjoys a standard deduction of 30% on the rental yield. The 30% standard deduction on rental income is given to cover maintenance and repairs costs borne by the property owner. However, the actual costs of maintenance are much lower, so the 30% deduction results in net savings for homeowners. That’s not all. Homeowners can also claim deduction on interest on the home loan taken to buy the asset. Both these tax sops are not available for any other asset class (see graphic). Dividends from stocks and interest from fixed deposits are both taxable at slab rates, with no deductions allowed.
So, why does real estate get this special treatment? “The government offers all these tax benefits on real estate as it wants everyone to own a house," said Karan Batra, managing partner, Chartered Club. However, many people utilise the tax benefits to invest in multiple real estate properties, beyond the primary house they live in. Nishant pointed out that it’s a common practice among high net worth individuals (HNIs) to opt for a loan to finance the properties that they buy for the purpose of rental income even when they have a surplus to cover such purchases.
Even when you live in the house that you buy, you can deduct up to ₹2 lakh as loan interest while calculating ‘income from house property’ in the income tax return (ITR), under section 24 of the income tax Act. While this results in loss from house property, such loss can be set off against any other income of up to ₹2 lakh in a year. The remaining amount can be carried forward to up to eight years. “In your ITR, under ‘income from house property’ head, you can declare GAV (Gross Annual Value or rent earned) of the property you live in as zero and claim the interest paid on the loan as deduction. This results in a loss from the house property equivalent to the interest paid, capped at maximum ₹2 lakh in a year," said Nitesh Buddhadev, founder, Nimit Consultancy.
For instance, let’s assume you are servicing a ₹50 lakh home loan taken at 9% interest rate with a 25-year loan tenure. The total interest component in the first year is ₹4.47 lakh. If you avail ₹2 lakh interest as deduction, you can save tax to the tune of ₹60,000, assuming you’re in the 30% tax bracket. So, instead of ₹4.47 lakh, you just need to pay ₹3.87 lakh interest, which brings down the effective interest rate to 7.8%. If the loan on the said property is jointly taken by a husband and wife, they can claim ₹2 lakh deduction each, which means the effective interest outgo further comes down to ₹3.27 lakh or 6.5%.
In the case of rented out properties, the reduction in interest rate highly depends on the rental yield, says Nishant.
“For residential properties where the yield is 1.5-3%, the net savings will not be much. Tax benefits translate into higher savings on properties let out to grade A commercial tenants as the yield is higher. For residential, the better option is that both husband and wife buy the property for their own use on a joint loan and claim a total of ₹4 lakh deduction on the interest. Low rental yields may not move the needle much on rented out properties," he said.
Jain’s is a case in point who has rented out his property for professional activities and hence earns a higher yield of 7.3%, akin to commercial rental yields.
Take note that only two properties per person are allowed to be treated as self-occupied. Beyond these, the owner has to pay tax on rent that accrues from other properties. If the property is vacant, it is considered deemed to be let-out and tax is paid on the notional rent. Notional rent is derived by comparing standard rent, decided as per the Rent Control Act, municipal rent as decided by the local municipal authority, and fair rent, which is the actual rent being paid on similar properties in the same area. The higher of municipal rent and fair rent is compared with the standard rent, and the lower of these two is the notional rent.
Retail investors should not see these tax benefits as an opportunity to direct all their savings in acquiring multiple properties as real estate. As an investment, it lacks liquidity and buying property to get rental yields has several unquantifiable risks. For one, letting out property runs the risk of rent default and tenants not vacating the property on time or not vacating it at all, which leads to prolonged legal disputes. More importantly, you have to bear the stamp duty cost of 5-6% each time you buy a property. You can claim this under section 80C, subject to the ₹1.5 lakh cap, which will in most cases fall short.
