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Economy

Building affordable housing by curbing bubbles in real estate

As part of my pre-budget articles: I wrote at Yahoo about our overenthusiasm for real estate and how we can curb bubbles in there.

More than 2.6 crore houses are required in India, with more than 99% required for the economically weaker sections of society. To achieve this, the government has provided substantial impetus for housing, and some of it is in the wrong place. However, housing is an important part of the budget and GDP activity. If we need to provide lower cost housing, we actually need to lower the cost of housing.

That means we have to reduce the “bubbly” nature of the real estate game and reduce the concept of property to a functional object rather than a store of wealth. This can be achieved by switching tax rules to disincentivize speculation in the property market, and instead, incentivize homeowners that actually live in the houses they buy. The other objective of the budget is to increase revenue — a need never seen quite as important as in the forthcoming budget, when our deficits will be gargantuan and the government will want to increase tax revenue.

Today, a tax cut for interest paid exists upto Rs. 150,000 per year, for the house you live in. At the rate of 11% a year for a housing loan today, that translates to a loan of just Rs. 13.6 lakhs, and if you consider the 20% down payment that you must put, for a house valued at about 17 lakhs. . That would buy you only the tiniest house in Delhi or Bangalore, and a matchbox in Mumbai. If people pay more for a house, they will pay more interest than they can deduct from their taxable income. Since the RBI gives preferential treatment (discussed later) to housing loans less than 25 lakhs, and the finance minister might find it justifiable that the interest exemption be extended to Rs. 250,000 per year.

But if you buy a second house, what is the maximum amount of interest you are allowed to deduct? Answer: there is no maximum. The Rs. 150,000 only applies to the house you live in; if you buy a second one and expect to rent it out, you can claim ALL the paid interest as a deduction. This, you might argue, makes complete sense — after all, renting out a house is a business, and interest is a legitimate cost of running that business.

Not quite so. In the current tax rules, you already get a 30% deduction from rent earned — no matter what magnificent amount you receive — as a deduction for sundry expenses. Hardly any house that rents for Rs. 20,000 per month has expenses of Rs. 72,000 per year (landlords might be lucky to spend that amount in five years!).

Secondly, the devil is in the often missed details. In India, rental yields are very low — of the order of 2-3% of the property value. So if you buy a house for 1 cr (Rs. 10 million) you might only be able to rent it out for, say, Rs. 20,000 per month, or Rs. 2.4 lakh per year. Net of the above 30% deduction, the real “income” is only Rs. 168,000.

But the interest cost on a loan for the same house, at 11% a year, may be as much as Rs. 900,000. (Assume the loan is for Rs. 80 lakh, at 11%).

The difference — of more than 700,000 – is a loss from house property — a loss that you can offset with anything, including salary income. This sounds fair — after all, I lose money somewhere, and I make it elsewhere, these balance out, right?

Wrong.

Our tax laws do not allow “balancing out” of losses under any other kind of income with each other. That means, if you make losses in short-term trading of shares, you can’t offset that loss with your salary; you have to wait till a subsequent year gives you profits in share-trading. So you’ll lose money on the trading, and also pay tax on the salary. What losses you make in one “head” of income cannot be offset by income in another head. The concept also applies for losses made in proprietary or partnership businesses (such as for doctors, lawyers or professionals) or speculative losses.

This rule miraculously does not apply for housing. Losses in property can be offset against income in any other head. This is a grossly perverse incentive in favour of buying a second property, which only causes speculation in real estate and increases costs for primary homeowners.

The Finance Minister must remove the 30% arbitrary expense deduction clause, and make any deductions based on actual expenditure only. Secondly, losses from housing property should not be able to offset gains in any other “head”; so salary income cannot be offset by losses made by investing in a second property. This would bring speculation in housing in par with starting a personal business, which is a more fair proposition with the advantage of curbing bubbles in real estate.

The third kind of incentive we provide is “priority sector lending”. The RBI allows banks to allocate lesser capital to loans that are provided against houses that cost less than 25 lakhs. This is misused by builders, who convince customers to take a loan three years before the property is constructed and promise to pay the interest; the catch here is that if the builder asked the bank for a loan, he wouldn’t be a “priority sector” borrower and therefore, would get a much higher interest rate for the money. This loophole gives builders access to money at lower rates, and instead of using it to deliver faster they create more “under construction” properties to gather more money. Additionally, such a scheme, where the builder pays a borrower’s EMI, is likely to be judged as taxable income for the borrower; since it is his expense that is borne by the builder. It may be in the government’s interest to clarify that builder-subsidized-EMIs will be treated as income for the borrower, and thus curb another unnecessary perk for home prices.

We are among the only countries in the world that subsidizes the principal repayment of a housing loan, under section 80(C). The Direct Tax Code, applicable only from 2013 if the Parliament functions long enough to pass it, will remove this deduction. But I expect the Finance Minister to consider removing it this year.

Finally, there is the capital gains tax-saving incentive. If you make taxable long term capital gains of any sort — by selling shares or government bonds, selling gold or selling your property, you can buy a residential property with the proceeds and not pay that capital gains tax. Since the only other comparable avenues (of saving capital gains tax) are buying NHAI and REC bonds at 6% interest, we are equating buying a house with investing in the country’s infrastructure. This is an overreach that requires correction.

With all the skewed incentives, the price of residential real estate has gone up substantially over the years. The cost of cement, sand and concrete have not changed so much, so the price rise has little to do with the cost of building the house. It has everything to do with the “feeling” that real estate prices must go up; but it is in the nations interest that we don’t let it get overboard. If there was anything to learn from the crisis the west has just gone through, it is that housing creates enormous bubbles. It is better to think of a house as a place to live in rather than its current market value; but the lobby of builders, brokers and real estate speculators has a strong representation in government and they will fight policy reform every step of the way. Over to you, Finance Minister.

  • Kaushik says:

    Claps Deepak for your transparent thoughts but as we have a patchwork govt,I strongly believe the juggernaut will go on for a while until ppl one day see all the properties have got transferred to banks hand and all indians have become permanent debtslaves.

  • Neelima says:

    Fantastic article, Deepak! I really like it how you spell it out 🙂 Looking forward to reading an article on whether it makes sense to even buy your first house in today’s time.
    Neelima

  • Anonymous says:

    Where is the F***ing Real estate regulator, they keep talking about every few months? If real estate is an investment, who sets the rules (like SEBI, RBI)?

  • prabe says:

    I doubt these changes will ever come in place… real estate being one of prime spot for black money and as you mentioned lobbying which is strong enough to even curb the thinking of any change.
    I would assume it is best to have the bubble burst in one point in time for everyone to learn the lesson.But will we learn a lesson from the burst is another question.

  • Krish says:

    Let us think from other dimension as a common urban person ‘Rahul’ point of view who is employed in IT/Finance sector and wanted to buy a property in Metro.
    A decent house costs a Crore these days excluding registration/stamp duty. The buyer downpayment is 20%. For other expenses like registration/stamp duty, amenities (some are not covered by bank loan), interiors etc.. would cost another 20 lacs. The buyer equity is 40 lacs and bank equity is 80 lacs (assume it is taken on home loan). Here are the buyer risks.
    If underconstruction property is brought, the buyer can’t get any tax break until the possession (3-4 yrs normal time).
    No gurantee that builder ever finishes the property (in one of your article, you have highlighted the risks)
    Interest rates on floating rate always rises aimed at making the buyer moderan day slave.
    The ever rising monthly maintenance payment always emptying the buyers pockets. I wish to see the stats that how many have repaid even the 1 lac principal to take the tax advantage.
    The tax incentive of 1.5 lacs is applicable only on bank loans portion but not on our own equity. This constitutes 10-15% of the interest portion that we pay to the bank which is just a tiny incentive from the government.
    The price escalation is always blamed on speculative buying. Yes, the raw materials costs and labour wages have moved inline with the inflation and may not be contributory. However land acquisition prices gone up sky roof. Even the governments caused this havoc going for the public auction of their lands and political parties lobbying hard on behalf of farmers demanding massive compensation.
    There is no doubt that an ‘ordinary buyer’ who is contributing to the economy by kicking in several activites from land acquitions, building houses, banks lending loans, employment to labour/brokers/banks/suppliers is rewarded very little from the government. Unfortunately this article thinks otherwise.

    • You don’t get a tax incentive for buying cars or paying interest on your car loan even if car companies employ a lot of people. not even for motorcycles. You don’t get a tax incentive for starting a business, which can directly employ people (okay if you start a big company you might) You don’t get a tax incentive for using the mobile phone, drinking coffee or such. But you do them anyhow, and these industries are heavy employers. If the price of cars goes up, we buy lesser cars. That’s how prices work. If we remove the tax incentives for housing, people will buy less and bring prices down, eventually; and because we will then make it equivalent to investing in any other business, we will get more appropriate pricing.
      Public auctions are a good thing. If the price is too much, don’t buy. That will bring prices down. Auctions are the only correct way to get landowners the rightful prices of their land.
      Ordinary house buyers that speculate in property need no more incentive than those that build a small business. All I’m saying is that we give housing too many incentives – we need to cut them down and just include the only one that might make sense (allowing an interest cost write off on the house you own) and nothing else.

  • Anon says:

    Very informative.
    Where would the legislators park their moneys if they passed these laws?
    Who finances the builders?
    In some cities the mafia has a strong grip. The prices will never come down. The govt holds it up.

  • Venkat says:

    Hi Deepak,
    To generalise and say 30% maintenance is very high is incorrect. In Mumbai, where rent is around Rs35-45000, the maintenance charges alone to Society varies from Rs 6000 to as high as Rs10000 per month!

    • First, rents also tend to be exclusive of maintenance, a norm now increasingly being followed by owners in my exp in Delhi/Gurgaon at least (My stay in Mumbai was “inclusive” but maintenance there was <10% of rent). Second, What I'm seeing is that such charges are just 10% on average where I live - the max I've ever seen was about 20%. By and large, these are tiny exceptions (and in most cases they are not even exceptions: even 10K maintenance for a 35K rent is less than 30%.) 30% is way beyond the normal realm of expense in this regard.
      Every rule will have exceptions - you will always find some apartments somewhere where maintenance is 60% of rent, for instance. Such owners must suck it up themselves, beyond the 30%; they always have the choice of selling off such apartments and buying one which conforms.

  • Sreekanth says:

    Only one big problem. If somebody does dare to change these rules, there will be too much backlash. Too many people are into this now, including the normal middle class folks. And if these changes are made, their properties might cost much lesser than what they had bought it for. So, nobody will dare make these changes, and so people like us even if we understand how skewed the housing market is, have no choice but to invest in it. I don’t think I will see this change in my lifetime.

  • Aditya Shenoy says:

    Can I say a word Deepak? …. why don’t we simply look at it this way. There are two kinds of money black and white, respectively there are two kinds of buyers – one’s those who purchase through black money and create the scenario that is, and the one’s who cannot buy except from their hard earned white money for which everything is taxable.
    So my point is, although it might sound highly ambitious, just make all your policies white money driven (favouring the taxpayer) and let the black money spenders find their own way of parking / re-investing their money.
    That’s it …. and see the change.

    • I wish that were a solution, but it creates a slippery slope. This is the current scenario. Everyone knows that black money is parked in real estate. No one enforces action. All policies only favour white money. So therefore, this is the current status quo and I see no change whatsoever 🙂 Would rather we enforce strongly.

  • Dushyant says:

    I want to buy a car & house on loan, but the EMI will almost be the same if i buy either.
    the catch is i can buy a car for 10 L but not house, it will cost 30-40L.
    I think i shud buy a small home in a non premuim location @ 10L and sell it later at some high price to purchase the house i want, but by the time i will sell 10L house in 20L , cost of 30L house will also rise to say 50L . then i will be stucked in a never ending loop . what to do 🙁