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Tax is applicable where there is income and essentially there can be only two kinds of incomes related to property — rental income and capital gains when property is sold.
Tax on rental income
The basis of calculating income from house property is the rental value. This is the inherent capacity of the property to earn income. Property income is perhaps the only income that is charged to tax on a notional basis. This charge is not based on the receipt of any income per se, but is on the inherent potential of the house property to generate income.
The first property that one buys is exempt from income tax, but only if it is not let out on rent. A notional rent value based on the market rental value will be adopted as taxable income from second property onwards, even if it’s kept under lock and key.
To put it differently, even if you earn no income whatsoever from the second property, it will be taxable as if you have put it out on rent. Therefore, it is advisable to rent out the second property since you will be obliged to pay tax on an assumed rental value.
When a property is not let out or is self occupied, only that property is exempted from tax.
There are two types of tax deductions available on income from property apart from the actual municipal taxes paid. The first is standard deduction of 30%. This means 30% of the rental income can be reduced as a standard deduction for repairs, maintenance etc. irrespective of the actual amount spent, if at all, during the financial year.
The second deduction, which is over and above the 30% standard deduction, is to do with interest on mortgage finance if the property is purchased on mortgage.
In case the property is tax-free, the interest deduction is restricted to Rs1.5 lakh. In other words, irrespective of the amount of interest paid, if you do not pay any tax on the property, the deduction on account of the interest paid has a ceiling of Rs1.5 lakh.
However, for properties that are taxable on either actual rent or notional rent, the entire amount of interest paid without any limit is deductible.
Nowadays, due to high property prices, in almost all cases, the interest amount far exceeds the rentals. Investors generally buy properties for the capital appreciation potential and put it on rent so that the asset does not remain idle and is maintained. However, today rental yields have fallen to around 3-4% pa.
For rented properties, the entire amount of interest payable can be adjusted against the rent and any amount that is left over may be carried forward in the tax return as loss from property to the next year.
This is very important from a tax planning point of view. Such carry forward of the unabsorbed interest can be done for a continuous period of eight years.
Over the years, as the loan gets paid off, the interest component that is getting set-off against the rental income each year will keep on reducing. On the other hand, typically, the rent would tend to increase (increment) each year.
This will go on to lead to a positive differential between the rent received and the interest paid and this difference would be taxable. At this point, the carried forward interest will be extremely useful to reduce tax liability.
If you wish to carry forward loss, it is mandatory to file the tax return by July 31 (for individual taxpayers). Without filing the tax return — and that too by the due date prescribed — carry forward of loss will not be allowed.
Interest deduction on a property can be only after taking possession of it. Often people buy properties under construction where the mortgage payments begin during the construction phase itself. So what happens to the interest paid pre-possession?
Such interest can be claimed for tax deduction in five equal installments starting from the year in which the possession is obtained.
For instance, say someone has bought a property under construction in FY 2008-09 and is paying an annual interest of Rs20 lakh. He gets the possession in FY 2010-11.
Therefore, he has paid a pre-possession interest for 2008-09 and 2009-10 of Rs40 lakh. One fifth of Rs40 lakh, that is Rs8 lakh, can be claimed during 2010-11 over and above the Rs20 lakh that he may pay in 2010-11.
Therefore, the deduction of interest for 2010-11 would be Rs28 lakh (Rs20 + Rs8 lakh) assuming the property is rented or else the deduction is restricted in to Rs1.5 lakh. Next time we shall examine in detail the capital gains that arise from sale of property.
The writer is director, Wonderland Consultants, a tax and financial planning firm. He can be reached at email@example.com
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