When buying a house, you have two financing options; either take a loan, or use your own funds. Most of us obviously would not be able to afford the outright purchase of a house without availing of a loan.

However, even those fortunate few who have the money to buy a house off the shelf should consider going in for a loan. Let us see why.

Well, for starters, under Section 24 of the Income Tax Act:

• Interest outgo up to Rs 150,000 on a housing loan is tax deductible for self-occupied houses.
• In the case of commercial properties and let-out premises, there is no upper limit on the deductibility of the interest.
• Anyone who has two self-occupied houses has the privilege of choosing any one of them as deemed to have been let-out.
• Over and above this deduction on interest, repayment installments of the principal loan amount are also eligible for deduction under Section 80C, within the overall aggregate ceiling of Rs 1 lakh (Rs 100,000).

If one were to use one's own funds, all these benefits have to be forgone. There are absolutely no tax benefits available for someone who buys a property outright without taking a loan. This does seem a bit harsh and unfair, but that's the way the law is.

Also, interest rates payable on housing loans are typically about the same as the rate earned on a bank deposit. Therefore, it makes abundant sense to take a loan.

So, how much loan should one take?

The answer is obvious:

1. In the case of commercial, let-out, or deemed let-out properties, take as much loan as can be obtained.

2. First Cut: In the case of a self-occupied house, a housing loan of about Rs 15 lakh (Rs 1.5 million) would attract annual interest of Rs 1.5 lakh (Rs 150,000), which is the highest limit of tax deduction available. So, loan up to this limit is certainly beneficial; anything more would not offer any additional tax benefits.

For instance, if you take an additional loan of Rs 1 lakh (Rs 100,000) over and above Rs 1.5 lakh, the corresponding additional interest of Rs 10,000 payable would not be tax-deductible. Now, the same corresponding amount invested in bank FDs earns interest of Rs 10,000. This is subjected to tax at the rate applicable to the individual and will be as much as Rs 3,399 in the highest tax zone. This is certainly a loss that can be avoided by using one's own funds beyond the limit of Rs 15 lakh or so, the exact limit being governed by the prevailing interest rates.

It would, therefore appear that any loan where the annual interest exceeds Rs 1.5 lakh is not tax advantageous.

Second Cut: The above analysis is true for Year 1. Let us examine what the situation would in the subsequent years.

Suppose the loan is Rs 15 lakh and the capital repayment for the first year is Rs 1 lakh. The interest on Rs 15 lakh is Rs 1.5 lakh only for the first year. During the second year, the loan outstanding would have reduced by Rs 1 lakh, and the interest will also correspondingly reduce, so there is unutilised tax deduction in the second and subsequent years.

Therefore, it makes sense to take as much loan as is possible for as long a tenure as possible because while the entire interest in the first year, or a few initial years, might not be fully tax-deductible, total tax advantage over the life of the loan would be higher.

3. One important observation related with those who have two self-occupied houses. The second house will be deemed to have been let out even if it is not actually let out. The entire interest paid on the second loan is deductible, and this is over and above the limit of Rs 1.5 lakh for the self-occupied house.

Yes, at first glance this appears very attractive but there is a notional rent that will be added to the income, which dilutes the advantage.

Fine print, tax smart

Section 24 of the Income Tax Act allows for deduction -- "Where the property has been acquired, constructed, repaired, renewed or reconstructed with borrowed capital, the amount of any interest payable on such capital."

Note that the word used is 'payable' and not 'paid.' Therefore, if the housing finance company adjusts the entire amount of EMI towards the principal first, and debits the interest to 'interest collectable' account, the borrower will derive the maximum tax benefit.

A certificate furnished to the borrower indicating the amount of interest payable gives him a handle to claim the deduction under Section 80C on a larger amount without losing deductibility under Section 24, by even a paisa. The actual interest payment can wait until the principal amount is collected. Some employers, especially PSUs and banks, follow this practice.

In such cases since the deduction of interest is already claimed on accrual basis, one cannot claim it once again when the interest is actually being recovered. Under such a scenario, the individual may be given an option to prepay the entire balance of interest without any penalty at one go when the capital is totally paid off.

We hope some of the financial institutions, especially the more dynamic ones like HDFC [Get Quote], take a lead in changing their structure of EMI. As a matter of fact, housing companies will do well by giving an option to the borrower of choosing whether to (i) treat the entire EMI as interest in the beginning or (ii) treat it as repayment of the capital or (iii) apply the normal reducing balance method!

Excerpt from:

Taxpayer to Taxsaver (F.Y. 2007-08)

By A N Shanbhag

Publisher: Vision Books

Price: Rs 235.

A N Shanbhag is a best-selling author and a very widely syndicated columnist on personal finance and taxation.

(C) All rights reserved.

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