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Cutting Real Estate Down To Size


My article at Yahoo: Cutting Real Estate Down To Size on their Budget Site.

In an economy that is seeing ridiculous levels of increase in real estate prices, it is strange that we continue to give it sops, sometimes to an extreme. Let me list the ways real estate is “preferred” as a mode of investment.

First, you are allowed an income tax deduction of Rs. 150,000 on the interest paid for the home you live in. This, you think, is justified; you are also allowed a deduction (without limit) on any education loan. But it doesn’t apply to any other loan you ever take – car loans, personal loans, a loan to buy that fridge that ensures your food doesn’t rot and so on. I would recommend that either all interest paid on a loan for ANY durable – like cars or fridges – be tax free. After all, the government charges the bank income tax on that money.

Or, they must remove the special exemption for housing loan interest completely. Education loan exemptions are far less kind; they should stay, for the only reason that education is far more useful. A house is only as useful as a car nowadays.

Second, if you buy a second house, you’re allowed to deduct an unlimited amount of interest paid on the loan. Again, just because no other item on your personal balance sheet is allowed that kind of deduction, I say remove it for housing, or let everything else in. How can you incentivize SECOND houses, for goodness sake!

Third, lower housing loan rates. Have you ever wondered why you get cheaper housing loans, but no other type of loan is cheap? It’s not the fact that the “collateral” – the house itself – is easily sellable, and housing prices don’t go down. No, if that was the case, I should be able to get a cheap loan if I give my house as collateral against, say, a personal loan. And I can’t – those rates still stay beyond the 18% range, while home loans are at 10%.

The answer is in the “risk weight” of housing loans. Banks are allowed to borrow (deposits) and lend (loans), but they have to have their own skin in the game. The amount of such skin is determined by the the kind of loan – a housing loan (for acquiring a house) gets a lower capital requirement than, say, a car loan or a personal loan. A bank has only that much capital, they can lend out more money where they have a lower risk weight and not quite as much to others, so housing gets a better interest rate. RBI has been trying to fix this recently by providing for a much higher risk weight when the loan crosses 75 lakh rupees, a good sign.

Fourth, you even get part of your principal repayments – upto 100,000 under 80C, an overall limit that includes a lot of other entries like insurance and children’s education payments. But this is silly, really – it penalizes people who pay outright for a house (without a loan) or who pay a larger down payment.

Fifth and finally, negative gearing. Let me explain with an example. Let us say you’re a salaried person making 5 lakhs a year. And you have a second house – for which, you have taken a loan of Rs. 40 lakhs, at 10% interest. You receive Rs. 10,000 per month as rent.

You end up paying Rs. 400,000 as interest, and receive only Rs. 120,000 as rent. Without going into technical details, you have a “loss” of Rs. 280,000. This “loss” can be adjusted against ANY other income you have in that year, including your salary!

In no other asset can you do this. If you have a loss buying and selling shares, you have to offset that against gains made in FUTURE years in shares. And that applies for business losses, speculative losses and so on. You can’t offset any income – specifically not salary income against losses made under any other “head” of income, except if you lose money in housing.

Apart from all this, we provide exemption from capital gains if you sell a house and buy another one – but the tax law specifies it only applies to people who have one house.
This is just going too far. Obviously this drives people to put in bad money after good in real estate, because they get a great deal, at the cost of other potentially better yielding investments. Prices just keep going up. There have been crises driven by real estate overheating in the UK, Spain and the US. What will it take for us to understand that our policies are bubble-inducing? We give housing way too much importance. There are far more productive assets – putting in equity, education or transportation is more productive.

We do have incentives elsewhere; equity for instance has the bubbly issue of having no capital gains taxes for selling after one year. FIIs pay no taxes in India if they come through Mauritius. You get tax saving equity funds. But all these have a sunsets – with the direct tax code some of them go away, and Mauritius treaties too have been under attack and could be reworked(and for good reason). The SEZ players also have only a certain time before they get back to becoming tax paying entities. IT exports only got tax exemptions till recently.

Housing, on the other hand, has seen no outrage, no demand for a level field with respect to other investments. If you ask me, we must discourage housing investments and bring them on par with other productive investments, like entrepreneurship. Make land cheaper. Innovate in construction. (For a start: encourage the use of insulation, double layered glass, high density Styrofoam or pre-fab housing. Saves enormously on cooling and construction costs) Once land and shelter is cheap, you can build the mega-shops, industries without spending too much on the least productive in the process: the real estate.

Pricking the real-estate bubble will be very painful. It is a huge demotivator, and it has massive implications to the financial system. It is also a big employer, but then so is beedi manufacturing, and perhaps it employs so much because we choose to promote it. The ridiculous incentives to real estate harm our system, and we don’t need hypothetical examples why: the west has shown us how bad real estate bubbles can be for economies. We either bite the bullet now, or create a worse situation later, and it may already be too late to prevent a recession. Policy measures must be taken in this budget to reduce incentives for housing if we are to avoid the path the western economies have taken.

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