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How real estate investments will shape up under DTC
July, 29th 2010

The proposed DTC says that in case of more than one self occupied property, the gross rent will be deemed as nil.

Recently, I met up with my childhood friend Rahul over a cup of coffee. In the course of our discussion, Rahul mentioned how he has been actively investing in real estate over the past decade and the well-thoughtout strategies he has applied to ensure decent returns from his investments. When I heard about his future plans for continued investment in real estate, I shared my perspective on the need for a reality check on anticipated earnings in the light of the proposed taxation policies and the fact that the real estate sector on the whole and big (real estate) firms are still reeling under the impact of the slowdown seen in the last couple of years.

The existing tax laws

Rahul, a zealous investor, listed out the several benefits on income from house property that are available for an individual under the current Income-tax Act. Ranging from deduction of municipal taxes, standard deduction of 30% on gross rent to deduction of interest related to the pre-construction period and annual interest on loan paid during the fiscal year. Further, the availability of cost indexation in case of sale of long-term capital assets accompanied with exemption if sale proceeds are invested for the purchase of another house property is always an incentive, he added. Obviously, Rahul had done his homework well, but it was time for him to know about the proposed changes, which may come into play very soon.

The proposed laws

Rahul listened patiently as I decided to take him through some of the changes proposed under the Direct Taxes Code (DTC) that shall impact investment in real estate. I shared the flip side as well as the upside to help him make informed decisions and tailor his return expectation accordingly.

The upside

No tax on rent from self occupied property: The proposed DTC says that in case of more than one self occupied property, the gross rent will be deemed as nil. This means no taxation for properties not let out during the year.

Early long-term indexation: Though, on the face of it, the distinction between a short-term investment asset and long-term investment asset has been done away with under the proposed DTC, but for computation of capital gains, indexation will be available for assets acquired any time after one year from the end of the fiscal year. This provision, therefore, reduces the life of long-term assets from 36 months under the Income-tax Act to a maximum of two years under the proposed DTC and, accordingly, provides early benefit of indexation.

Increase in cost of acquisition for assets acquired in 1981 to 2000: The cost of acquisition is generally (reached at) with reference to the value of the asset on the base date orif the asset is acquired after such datethe cost at which the asset is acquired. The base date will now be shifted from 1 April 1981 to 1 April 2000. As a result, one could say that the increase in cost of acquisition leads to a gain, wherein capital gains between 1 April 1981 and 31 March 2000 will not be taxed.

The flip side

Standard deduction at 20%: DTC proposes to reduce standard deduction on repairs and maintenance from 30% allowed under the Income-tax Act to 20%. Less deduction is tantamount to increase in tax liability of an individual.

No deduction on interest in pre-construction phase: The proposed DTC does not provide for any deduction on interest related to the pre-construction period over five years on loan taken for purchase/construction of house property. This provision will impact an individuals decision to invest in ready-to-move property over developing/under-construction property.

Withdrawal of deduction on interest for more than one self occupied property: This is a huge setback for individuals who bought property on loan for self occupation.

Tax on sale: Since the distinction for taxation purposes between short-term investment asset and long-term investment asset has been done away with under the proposed DTC, the capital gains on such assets will be included in the total income of the taxpayer and will be taxed at the applicable slab rates, instead of the earlier rate of 20%. This change will increase the tax liability of those in the higher income group as they will have to pay tax at 30%.

Further, the Income-tax Act provides for exemption under section 54 of long-term capital gains arising on the sale of a residential house if the sale proceeds are invested for purchasing another one. However, under the proposed DTC, there is ambiguity on the availability of deduction on purchase of a residential house upon transfer of a residential house if an individual already owns one house (other than the one he is selling).

As Rahul sipped the remnants of his coffee, he nodded meaningfully, possibly realizing that his favourite investment may lose its sheen. Once the proposed DTC gets implemented, he may need to rethink whether investing in real estate would give him the same tax benefits that he has been getting all these years.

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