Stop the ongoing real estate monetisation scheme

My grandfather used to tell me about the abundant availability of rental housing in Mumbai, though at high levels during the time (probably the 1930s) when he first started working in the city, then Bombay. To save on rent he used to surrender the premises to the owner when he took his annual vacation back to our ancestral village in Rajasthan every summer, as he always got back either the same premises or in the same building or area. Retail home loans were unheard of and only rich businessmen or trusts floated by them owned buildings. Everybody else stayed on rental premises. The party lasted till the Second World War, when the Rent Control Act first came in (and stayed on as an unwelcome guest till now). Real estate rental yields were never the same again. The capital gains on real estate in those days were never high anyway and the absence of loan availability ensured the common man did not have the ability or incentive to purchase his own home. The governments wanted to encourage investment in real estate because of its known positive impact on the overall economy.

The way yields and capital gains on real residences were taxed reflected this scenario. The Income Tax Act 1922 (the precursor to the current Income Tax Act 1961) taxed rental incomes (including deemed rental income on self-occupied properties). Obviously there was no concept of a “loss” arising from the property. The Act of 1961 introduced the concept of capital gains tax for the first time. To encourage investment in real estate, it had a number of measures which can only be referred to as the real estate monetisation scheme (on the lines of the proposed gold monetisation scheme) which was immensely successful. Section 54 exempted the capital gains on residential houses if it was rolled over into another house property. Section 54F was introduced in 1982 to encourage transfer from other asset classes into real estate. It was further liberalised in 2000 to allow even existing property owners to participate in the bonanza. The tax breaks were ongoing, since “loss from house property” is allowed to be adjusted against other incomes, including salaries and business. Given the low rental yield and then the increasing use of loans to purchase houses, the calculation invariably resulted in a loss, which gave an excellent tax break to the owners. The common man buying a house for own use was fobbed off by making the deemed rental income nil and interest deduction up to ~30,000. Over a period of time this has increased to ~2,00,000.

To summarise this is how the tax structure looks. For common people who only ever hold one residential property, the deduction for interest is restricted to a maximum loan of around ~20,00,000 and the capital gain relief on sale is meaningless since he anyway will buy a new house to stay in. Meanwhile, the investor enjoys the estate monetisation. First, the purchase of property acts as a store of black money and the white portion is funded by easily available loans. The rental yield being low does not matter, as he is able to get substantial benefit from the “loss” he incurs. On sale of the property, he obviously rolls it over into another property, thereby legitimising the original unaccounted money he invested plus, he gets opportunity to invest further unaccounted money that he may have generated in the meanwhile. Those holding other asset classes are also encouraged to get into this bandwagon by Section 54F. The Income tax act is designed to favour the laundering of black money through real estate and also to keep that money locked into real estate.

The obvious thing to correct this would be to:

1) Allow full deduction for interest payable if the self- occupied property is the only one owned by the tax payer.

2) Don’t allow the loss under income from house property to be set off against other heads of income. It can be carried forward and set off against future income from house property, if any

3) All capital gains exemption on investment in residential property to be available only if the property purchased is the only property owned by the tax payer.

I don’t have access to data but I am reasonably sure these changes will result in overall higher tax collection for the government, make the common man happy and disincentivise the holding of unaccounted money in real estate.

If the government really wants to boost the householders’ investment in financial assets, it should bring back Section 54E (discontinued in 1992) whereby the capital gains were exempt if invested into specified financial assets. But despite all the lip service to promoting investments in financial assets, that would probably be too much to hope for.