The highlight of this year’s Union Budget was removal of indexation on property. The public outcry was so intense that the government had to partly roll back the decision. It reintroduced indexation for those who had already bought the property when the change was announced on 23 July.
For real estate bought before that, owners can choose between 20% long term capital gains tax with indexation or 12.5% without indexation. For properties bought after 23 July, though, 12.5% LTCG tax without indexation is the only option. Many real estate investors are unhappy about this, but even without indexation, real estate continues to be the most pampered asset class.
Also read: Reintroduced indexation for property disallows loss offsets, excludes NRIs
Most pampered asset
Real estate buyers get tax breaks on both the loan used to buy the property and income earned from it, i.e, rent. On a let-out house, the full interest paid towards home loan can be deducted. In the case of a self-occupied or an empty house (not rented out), interest up to ₹2 lakh can be deducted. Effectively, this means ₹2 lakh is your loss from the property, which you can offset against your salary or any other income when paying tax.
As for rental yield, the government offers a 30% standard deduction. This is meant to cover maintenance costs, but in reality maintenance costs are usually less than 30% of rent, resulting in savings. The owner can also deduct property and municipal taxes paid during the year. No other asset class gets this deduction benefit.
Also read | No indexation: Sale of homes needs to be taxed at the same rate as salaried income
Combined, these tax breaks give prospective buyers enough leverage to invest in a property with a loan for rental income.
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Let’s explain this with an example. Say you buy a house with a home loan at 10% interest rate. You have rented it out and are in the 30% tax bracket. Since you get a deduction on the full interest, the effective interest rate drops to 7%. Also assume that the rental yield is 3% and the property’s value appreciates by 5% a year. After the 30% standard deduction, the taxable yield is 2.1%. After paying 30% tax on it, your net post-tax yield is 2.37%. On adding the 5% price appreciation, the annual rate of return works out to 7.37%, or 37basis points more than the interest. In this example, the net return on the house surpasses the cost of ownership.
This leverage is available even when one buys a house to live in and not as an investment. That’s because up to ₹2 lakh of loan interest that can be deducted results in a loss while calculating ‘income from house property’, reducing the effective interest rate.
For instance, say you have taken a ₹50 lakh home loan at a 9% interest rate with a 20-year tenure. The total interest to be paid in the first year is ₹4.47 lakh. After availing the ₹2 lakh deduction you save ₹60,000 in tax, assuming you’re in the 30% tax bracket. So, instead of ₹ ₹4.46 lakh, you have paid ₹3.86 lakh as interest at an effective rate of 7.78%. And if you’ve taken the loan with your spouse, you can both claim the ₹2 lakh deduction, which further reduces the effective interest payment to ₹3.27 lakh or 6.57%.
As you can see, tax breaks considerably reduce the effective interest rate on the loan, making the cost of borrowing quite low.
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Other tax benefits
Even capital gains from selling a house property are tax-exempt under certain conditions. Section 54 of the Income Tax Act exempts you from paying capital gains tax if you use the gains to buy another house. The only condition is that the new house should be bought within two years or constructed within three years of selling the previous house. This can safeguard house owners who only own one house for personal use from the removal of indexation. In all likelihood, such owners would sell their house only to buy another one.
Also read: Indexation benefit for property restored. But is it enough?
Under Section 54F you can save capital gains tax on other assets as well, including stocks, mutual funds and gold, by using the proceeds to buy a house. However, this section has more conditions. For one, the entire sale proceeds should be used, not just the gains. Second, this exemption is allowed only if the taxpayer doesn’t own more than one property when selling the asset. This exemption applies only to buying a house property and no other asset.
Apart from these tax benefits, interest rates on home loans are lower than those on business and personal loans, and even those taken against assets such as stocks, mutual funds and gold.
All of these benefits continue to keep real estate attractive from a financial perspective. Of course, buying a property to rent out involves several intangible risks that cannot be quantified.
