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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?


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.


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