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For those without a house of their own, buying one might rank as the most important aspiration. Even as they struggle to make their choicest dream come true, some are planning their second home purchase or are already there and looking for the right tenant.
What can explain this disparity? It could anything from post-tax increase in family income, the turning of the household into a double income family, or more savings in taxes. We'll see how tax planning can bring you not only your first house without any increase in the outgo on the house front, but also provide more than adequately for the EMIs of your second house.
We'll take a simplistic household model in terms of earnings and expenses.
Earnings - Tax paid for the month = Take-home income
Take-home income - Monthly household expenses (can include capital expenses) = Savings
Savings - Amount set aside as cash reserve for short-term exigencies = Investible amount
Investments generate earnings and the cycle starts all over again. Income from some investments is taxable. From others, it is not. You cannot avoid taxes, but can minimise the outgo by investing in tax-saving instruments mentioned in the Income Tax Act. The Act encourages investments in housing and infrastructure through special tax breaks for them.
Depending on the circumstances of each individual, these provisions can be used to minimise tax outgo.
Tax incentives on a home loan
Loan EMI = Principal + Interest
Annual principal repayment of up to Rs 100,000 can be deducted from gross total income under Sec. 80c of the I-T Act
If property is self-occupied, Rs 150,000 of the annual interest repayment can be deducted from gross total income under Sec. 24 of the I-T Act
If property is rented out, FULL AMOUNT of interest paid is tax-deductible
If you are living in a rented house, buying a house for self-occupation with a loan may make a lot of sense. Let's take an example to see how.
Assumptions: Highest tax bracket (30% + 10% surcharge + 3% education cess = 33.99%); tax breaks on principal and interest payments availed fully. The amount of tax saved may vary depending on interest rate and term of loan.
Outgo on house = Monthly rent = EMI-Tax saving
Thus, tax planning can turn you into a house owner from a tenant without any extra cash outflow. If at all the outgo on house after taking home loan is higher than the rent, monthly savings can bridge the gap. Have the loan structured by your banker to minimise the gap.
You can go for a second home if the first home loan is nearing the completion of its term and you have enough cash to back a second home loan. Buying a second home does not only have a financial, but also a psychological dimension. It may not be just about building another asset in your name, but also about the joy associated with the acquisition.
Tax breaks can again make matters easier for you if you buy the second house with a loan and rent it out.
Annual principal repayment of up to Rs 100,000 is deductible under Sec. 80c (for residential property, not for commercial property)
Entire annual interest payment is deductible (unlike the cap of Rs 150,000 on the first home)
The example that follows illustrates how, if you take a loan to buy your second home and then rent it out, the tax saving provisions of the IT Act mentioned above and the rental income that you receive can pay the EMIs of the loan on your behalf.
The main condition on which the calculations in the example rest is that you have cash for a substantial down payment. The reason is that monthly rent, as a thumb rule, is 0.3-0.5 per cent of the market value of a property. The assumption in the example that the house will fetch you a rent of Rs 20,000 implies that it will be in a locality where residential property would cost a lot more than the home loan figure of Rs 30 lakh (Rs 3 million) mentioned. Hence, a hefty down payment would need to be made to bridge the gap between the loan and the cost of the house.
Net loss, if any, from the property after taking into account loan payback can be set off against other incomes, including salary income.
You move to buy the same property as mentioned earlier when it is ready for occupation
Tax savings on second house
2.40 lakh *
Less standard deduction
Less interest on loan
2.24 lakh ***
Income/loss from house property
Deduction for principal repayment
* Monthly rent of Rs 20,000
** Standard deduction of 30%
*** Total EMI paid in a year, Rs 3.24 lakh, minus Rs 1 lakh paid as principal
The loss of Rs 56,000 can be set off against other incomes. Now, let us see how much tax you save
from rental income
Deduction u/s 80C
Loss under the head
Net tax saved (@ 33.99%)
Thus, rent and tax saving (Rs 2.4 lakh + Rs 77,498) can almost service your entire EMI if you rent out the house. The bonanza is, you will own a second house later and yet save on taxes!
Maintain a healthy debt-service ratio - the ratio of the total of all EMIs to total savings - as far as possible during the tenure of the first home loan. This figure tells you how far you can go in taking loans to build assets. All the EMIs taken together should not exceed Rs 40 for every Rs 100 earned. Stick to this ratio to ensure meeting other family expenses.
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