Of all taxable incomes, perhaps tax on rental income is most complicated as this is the only income that the Income Tax Act (ITA) taxes on a notional basis. In other words, the incidence of tax is based not only on the income earned from the property but also where no income is being earned, on the inherent potential of the property to earn income. Also, the exemptions and deductions differ as per the number of properties a person owns. Going by the number of emails we receive in the form of queries on this topic, this week we thought we should re-examine the subject in greater detail.
Basically, tax is applicable where there is income and essentially there can be only two kinds of incomes related to property – rental income and of course capital gains when property is sold.
The basis of calculating income from house property is the rental value. This is the inherent capacity of the property to earn income. As mentioned earlier, property income is perhaps the only income that is charged to tax on a notional basis. This charge is not because of the receipt of any income per se, but is on the inherent potential of the house property to generate income.
Property income is perhaps the only income that is charged to tax on a notional basis. This charge is not because of the receipt of any income per se, but is on the inherent potential of the house property to generate income
So first and foremost, the first property that one buys is exempt from income tax. However, the second property onwards, even if it’s kept under lock and key, a notional rent value based on the market rental value will be adopted as taxable income from the second property.
To put it differently, even if a taxpayer earns no income whatsoever from the second property, it will be taxable as if he has put it out on rent. Therefore, it would be advisable to actually rent the second property since anyway the owner will have to pay tax on an assumed rental value.
Note that this above discussion applies only in respect of house property; it does not cover a plot of land. Also, the first property is tax-free only if not let out. In other words, if you earn rent, whether from one property or more, all the rent is taxable. However, in cases where the property is not let out (or is self occupied) then one property is exempted from tax.
This was so far as tax on rental income was concerned. Now coming to tax deductions.
There are basically 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 of course, the property is purchased on mortgage.
In case the property is tax-free (on the lines mentioned above), the interest deduction is restricted to Rs 150,000. 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 Rs 150,000.
However, for properties that are taxable on either actual rent or notional rent, the entire amount of interest paid without any limit is deductible. In fact, nowadays on account of currently ruling property prices, in almost all cases the interest amount far exceeds the rentals. Investors generally buy properties for the capital appreciation potential and in the meanwhile put the property on rent so that the asset does not remain idle and also gets maintained. However on account of market appreciation, rental yields have fallen to around 3-4% p.a.
In any case, coming to the earlier point, 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 8 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 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.
Interest deduction can be claimed only when the possession of the property is taken. But often people buy under construction properties where the EMI or the mortgage payments begin during the construction phase itself
Obviously, this is an extremely important tax planning tool. But remember, if you wish to carry forward loss, it is mandatory to file the tax return by the due date of 31st of July (for individual taxpayers). Without filing the tax return – and that too by the due date prescribed – carry forward of loss will not be allowed.
One last point regarding interest
Interest deduction can be claimed only when the possession of the property is taken. But often people buy under construction properties where the EMI or the mortgage payments begin during the construction phase itself. So what happens to the interest paid pre-possession?
Such interest is to be claimed as a tax deduction in five equal installments starting from the year in which the possession is obtained. A numerical example will help illustrate the point. Say someone has bought a property under construction in FY 13-14 and is paying an annual interest of Rs 20 lakh. He gets the possession in current year 15-16.
Therefore he has paid pre-possession interest for 13-14 and 14-15 of Rs 40 lakh. One fifth of Rs 40 lakh - that is Rs 8 lakh can be claimed during 15-16 over and above the Rs 20 lakh that he may pay in that year. Therefore, the deduction of interest for current year 15-16 would be Rs 28 lakh (Rs 20 + Rs 8 lakh). This is of course assuming the property is rented – else the deduction is restricted in toto to Rs 1,50,000.