Wednesday, July 31, 2013

Everything you ever need to know about House Rent and Income Tax

One of the biggest points for confusion for most of us is about the Income Tax Aspects surrounding our House. Whether you live in a rented house or own a house that is rented out, there are significant Income Tax Implications. The purpose of this article is to explain these topics and clear things for you.

For People Living in Rented Homes:

If you live in a Rented House you are eligible for something called House Rent Allowance and this has tax benefits. If you check out your salary package closely, the will be something called "HRA" or "House Rent Allowance" that is part of your monthly salary along with other components like Basic Salary, Provident fund etc. If you dont have HRA as part of your salary, you need to discuss with the finance department of your office and make sure to allocate a decent chunk of your salary into the HRA Bucket.

Lets assume you have HRA as a salary component. So the next step is to calculate the taxation aspect of the HRA Component. In order to do this, you need the following:

1. Your Basic Salary
2. The Actual HRA Component in your Salary
3. The Actual Rental paid every month
4. Whether you live in a Metro or a non-metro

Once you have these details, try to calculate the following numbers:

1. If you are in a Metro - take 50% of your Basic salary and if not, take 40% of your Basic Salary
2. The Actual monthly HRA component from your salary
3. The Actual Rent paid - 10% of your Basic Salary

Of these 3 figures whichever is the least is your eligible tax deduction against HRA.

For ex: If your Basic Salary is Rs. 40,000 per month and you live in Chennai. Your actual rent paid every month is Rs. 20,000 and the HRA Component in your salary is Rs. 22,000. In such a case, how will you compute HRA?

1. Since you are in Chennai (Metro) you get = Rs. 20,000
2. Monthly HRA Component = Rs. 22,000
3. 20,000 - 4000 (10% of 40,000) = Rs. 16,000

So, among these 3 components, Rs. 16,000 is the least and hence you can claim HRA Exemption of Rs. 16,000 every month. This means Rs. 1,92,000/- will be deducted from your total annual income for tax calculation. So, lets assume your total annual salary was Rs. 7.5 lacs, after considering the tax deduction for HRA your net taxable salary is only 5.58 lakhs.

Some Questions from People Living in Rented Homes:

After reading the above example, I am sure you will have many questions. I have tried to answer some of them below:

1. Can I claim HRA if my own house is still under construction?

Yes, you can. As long as you are paying a rent to someone (and have proof for the same) you can claim HRA

2. My house owner doesnt give me any receipts. What can I do?

A simple rental agreement written on white paper and signed on a Rs. 1/- revenue stamp affixed in the letter should suffice. The actual rent paid and the person to whom it is paid must be clearly mentioned in the letter.

3. My owner is refusing to sign the agreement. What can I do?

Your owner is refusing because if he signs this agreement, he needs to show this as income for his taxes and hence is trying to escape. You need to explain to your owner before you occupy the house that you wont take the place unless he signs the rental agreement. If he doesnt sign, you cant get tax benefits even though you are actually paying the rental money

4. I am a bachelor. Can I show as if I am paying rent to my mom or dad?

Sure you can. However, your mom or dad will have to show this rent you are paying as an income for their taxation purposes.

5. My wife is a house wife. Can I show as if I am paying rent to my wife?

No, you cannot pay rent to your spouse. It is not allowed as per Indian tax laws.

6. Can I Pay Rent to my Mom or Dad and claim HRA Benefits?

This is a tricky question. Legally there is nothing stopping you from doing this but this is a concept that is frowned upon because effectively this amounts to cheating. In real life - would we really pay rent to our mom or dad? 

Anyways, if you insist on going this route, you need to understand that if your tax returns get audited in future, you would have to answer the tax officials on why you claimed as if you are paying rent to your own parents plus prove that you actually paid rent. Otherwise - the penalties you will pay and the consequences would be much worse than the few thousand rupees of tax you will save. 

If you wish to go this route - as a first step, you would need to apply for a PAN Card for your mom or dad (on whoever's name you want to pay rent). Only the person on whose name the house is registered can receive rent. If your father is employed and owns the house but you want to show rent to your mom who is a house wife - that is not allowed. After this you would have to sign a rental agreement on stamp paper and register the same for the amount of rent that is nominal for your area plus the size of your room. Once done, you must make sure to formally transfer the rent to your parents account plus ask them to issue a rent receipt so that you can use the same for tax filing purposes. 

For People who Own a House that is Rented Out

If you are someone who has rented out your house, you need to show that rent as an income along with your other sources of income. The taxation of your rental income depends on whether you have a loan running against this rented house or you own it fully. The amount that is considered for taxation could either be the Notional Rental for that area or your Actual Rent whichever is higher.

Option 1: Owned fully

In this case, if you receive a rent, 70% of the rent must be shown as income in your records. For ex: If your monthly rent is Rs.20,000/- you can deduct 30% of it as expenses incurred in maintaining the house & other charges. The remaining Rs. 14,000/- you need to show in your income.

So, let us say your annual salary is Rs. 5 lakhs from your employment, your total taxable salary will be Rs. 6,68,000/- (After including 1,68,000 of Rental Income)

Option 2: Have a Home Loan Running

In this case, the interest component of your loan is totally deductible from the rent you receive. Let us go back to our above example. You are receiving a rental of Rs. 1.68 lakhs as income. In case a home loan is running for this house where the interest you paid last year was Rs. 1.18 lakhs, you can deduct this from the rental income and show only Rs. 50,000/- as the net income because technically you are offsetting the interest & your rent.

Remember - You can only consider the interest component of your home loan EMI for this deduction and not the principal.

Nowadays, due to high property prices, in almost all cases, the interest amount far exceeds the rentals. Investors generally buy properties for the capital appreciation side of Investment and leave it out on rent so that the asset does not remain idle and is maintained properly.

Some Questions from People Owning Rented Homes:

1. What is Notional Rent?

Notional Rent is the guideline rental price that the government will consider for all its calculations. Technically this is the minimum price at which you are expected to rent out your house.

2. What if the Notional Rent is higher than the Actual Rent?

In the rare case that the actual rent you get is lower than the Notional Rent, you still need to consider the notional value for tax purposes. Remember the example above? In case your actual rent is only Rs. 15000/- whereas the Notional rent for your area is Rs. 20000/-, for all taxation purposes Rs. 20000/- only will be considered

3. My Rent this year was much lower than the Interest I am paying the bank on the home loan. Is there anything that can be done to help this situation?

Well, for rented properties, the entire amount of interest payable can be adjusted against the rent and any amount that is left over may be carried forward in the tax return as loss from property to the next year. This is very important from a tax planning point of view. Such carry forward of the unabsorbed interest can be done for a continuous period of eight years.

So, as years go by and the loan gets paid off, the interest component that is getting set-off against the rental income each year will keep on reducing. On the other hand, typically, the rent would tend to increase each year or at least once every 2-3 years. This will go on to lead to a positive differential between the rent received and the interest paid and this difference would be taxable. At this point, the carried forward interest will be extremely useful to reduce tax liability.

Remember - If you wish to carry forward loss, it is mandatory to file the tax return by July 31 (for individual taxpayers). Without filing the tax return by the due date prescribed this carry forward of loss will not be allowed.

4. This carry forward calculation seems complicated. What can I do?

Contact a tax advisor or a chartered accountant. They will charge you a small fee and do this for you without much hassle to you.

I hope this article answered all your major queries abut house rent from both the owners perspective and the tenants perspective. If you have any further queries, leave a comment below and I will try to answer them...

Thursday, July 25, 2013

What is the Best Gift You Can Give Your Family?

What is the best gift you can give your family? A new Car? An awesome vacation in Europe? A new diamond necklace for your beloved? A new PlayStation for your son? The list is endless. However, this isn’t what we are talking about here...

We all work very hard and try to save up money for our future, our family's future and retirement. In many cases we are the only bread winner for the family. With women going to work more & more, the % of families where the Man is the only bread winner is coming down by the day. Anyways, this article can be suitable for any individual who is gainfully employed and has a family...

So, What is this Gift?

This gift isn’t that simple. If I have to summarize it in three words the gift will be

"A Safe Future"...

So, how can you ensure a safe future for your family when we are around and even after we are gone? That is what this article is about!!!

Idea No. 1: Keep Debt to the minimum (Preferably Zero)

This could probably be the biggest gift you can give your family & survivors in the unfortunate event of our demise. Imagine the mental & psychological stress our family will be after our demise. To top it all off, imagine how much more harder it would be for them to repay debt that we did not repay yet. Even if we don’t leave them a million dollars in inheritance, at least we shouldn’t be leaving them with debt to repay after our time. Isn’t it???

So, what can we do to keep our debt to the absolute minimum?

Tip No. 1: Always choose higher monthly EMIs over longer durations. A 5 year loan at Rs. 5000/- per month looks more appealing than a 2 year loan with a Rs. 15,000/- EMI per month. However, the lower your tenure the lower the loan amount remaining with every passing month...

Tip No. 2: Always choose to opt for the Insurance coverage that comes with loans. Most banks these days ask if you are willing to sign-up for insurance to attach to the loan. If they do, don’t refuse. The few hundred rupees fee they collect for this would definitely be worth it in case anything unfortunate happens to us. The bank will use the insurance policy to cover for our outstanding amounts and will not disturb our family.

Tip No. 3: Always choose to opt for the credit protection plans that come with Credit Cards. Most credit card companies these days have credit protection plans that charge you something like 0.1% of your outstanding amount to cover for the payment in case anything happens to us. So, for a 10,000/- rupees statement outstanding on our credit card this will work out to something like Rs. 10/- and in case anything happens to us, the credit card company will claim this from the insurance and will not trouble our family

Idea No. 2: Buy Pure Term Insurance Policies to cover at least 10 years’ worth of your annual salary as Maturity amount

This is pretty straightforward. I have always been supportive of pure term insurance policies because they give the most bang for the buck we pay them. For ex: Rs.10,600/- per year could get an insurance coverage of 1 crore for a non-smoking 30 year old person. This investment may sound like something you will never get back but think this way, if you are to buy an insurance policy that actually gives you the same 50 lacs at maturity (after 25 years) you will need to invest approx. 2 lacs every year...

Pure term insurance policies are the best for risk coverage to ensure that our family has adequate financial backing in case of an unfortunate event.

Note: The example premium amount was taken from an online quote for pure term life insurance policies. The policy is a 30 year term where I pay this amount every year and if anything happens to me in the next 30 years, my family gets 1 crore.

Idea No. 3: Start Saving for your Retirement TODAY!!!

Most of us (Including me) have been working for many many years and always dream about starting to accumulate money for our retirement. The sad truth is, even after almost a decade of being employed my retirement corpus isn’t something I can be proud of. Unfortunately this is the case for almost everyone. We work hard to make ends meet and by the time we can think about saving for retirement we are just a few years from retirement and end up with not much or even no retirement corpus. This should not happen to us. Decide and start saving up for your Retirement.

There is a whole series of articles in this blog that cover topics like why we need to plan for retirement, how much money we will need, how to save up that money etc. You can read it here: Retirement Planning Series

Let us all decide to act on these 3 Idea's explained above and try to give our family a safe and secure future!!!

Wednesday, July 3, 2013

Read this before you buy a new ULIP Policy

This blog has seen its fair share of ULIP Products in the past and I have always been against ULIPs that charge exorbitant fees & charges from their investors as well as agents selling ULIPS just to make a fast buck. Unfortunately not many investors know about ULIPs and their fees & charges and have fell into the trap. The idea behind this article is to bring to your notice some shocking news I read in the new today as well as some suggestions for you if you are a prospective or current ULIP Investor.

Before We Begin:
I have always been strong in my views about confusing Insurance and Investment. Unfortunately the age old tradition of buying Insurance products for Investment is still prevalent in our nation and that is what has prompted this situation as well as this article!!!

So, what is this Shocking News?

Every year people surrender their Insurance Policies ahead of its maturity period even if it means incurring losses or penalties. You probably know that already. The actual shocking news is that in the financial year 2011-12 ULIPs comprised 97% of all insurance policies that were surrendered ahead of time by customers. This is the official % that was released by IRDA recently.

Is this really Shocking to me?

Actually No.

In May 2012, there was an article in this blog titled Should you Exit your ULIPs Now? which reflected the market sentiment about ULIPs. Personally I am not at all shocked to see this news because this was something that was inevitable given the fact that ULIPs were being sold like candies to the unsuspecting investor..

Why are customers selling ULIPS in this magnitude these days?

Reason 1: ULIPs are not investment products

Agents & Sellers of ULIP Products rarely mentioned the fact that ULIP Products are primarily Insurance products. Instead they sold them as investment products. Each of these agents had one fancy work-up calculation that would hypothetically predict a 20% or 30% returns year-on-year and say that if you Invest Rs. 2 lakhs per year for 10 years you will get something like 2 crores at the end of 15 years.

Not realizing that they are being lured into a honey-trap, unsuspecting investors bought these products with the hope that they too can be a "Crorepati" in 10 or 15 years.

Reason 2: ULIP Returns are linked to the Stock Market Performance

Agents & Sellers will never mention the fact that ULIPs aren't invincible. They will never tell you that your ULIP can make losses in case the market tanks. They keep lay the honey-trap so well that as an investor, you fail to realize that ULIPs can make losses and end up investing in schemes that are highly aggressive and invest almost the entire corpus in Stocks.

Reason 3: The Fees & Charges are not explained clearly to Investors

When the Agent is selling his ULIP Product to you, he will not mention the fees & charges the Insurance Company that is providing this ULIP Plan is going to deduct from your annual premium ever year. This is because these charges form a significant chunk of the premium you pay every year. So, realistically speaking around 10% and as much as 40% of your premium goes to the agent & his company just for selling this product to you.

Even in the mathematical work-up they show you, they will not consider this chunk that goes into their pocket and their calculation will always show that 100% of your investment is considered as an investment.

Reason 4: Investors are not told that ULIPs are LONG TERM and I mean REALLY LONG TERM investment products

Your Agent may tell you that the lock-in period is only 3 years and that you could exit any time you want after the 3 year period. Unfortunately what they fail to mention is that, in order for ULIP products to be really profit-making for the investor who is putting his hard earned money into it, the product has to be live for at least 10 years or more. ULIPs are long term products that can offer good returns after 10 or 15 years of staying invested.

Reason 5: ULIPs aren’t the only tax saving instruments

One of the biggest selling points for Agents is the tax benefit for Investors. There are numerous other tax saving products and many of them are 100% safe and don’t have the kind of risks that ULIPs have. So, don’t get fooled if your agent is trying to convince you that these are the best tax saving options. Unfortunately they are not. There have been many articles about tax saving in this blog.

Read the below:

1. Saving Income Tax through Investments
2. Life Stage based Tax Saving Portfolio
3. Best Tax Saving Options Available for Investment

So now, you are probably thinking, in spite of all this millions of investors did buy these products. What exactly went wrong?

What Went Wrong???

ULIP Providers are expected to send periodic statements to their investors. This was the problem. Read the timeline below from an Investors perspective...

Day 1: Mr. X Invests Rs. 1 lakh on ULIP ABC. Agent convinces him to invest in the Aggressive/Growth Equity plan because that can make him a Crorepati in 10 years

Day 90: Mr. X receives his end of quarter statement. He receives the biggest shock of his life. His unit holdings are worth only Rs. 65,000/- today because only Rs. 62,000/- actually got invested against his name 3 months ago after deducting all the fees & charges

Day 91: Mr. X calls up his agent and has an argument but gets stonewalled saying that these things were part of the Terms & Conditions and that he must've read them

Day 92: Mr. X thinks about cancelling his investment and continues his argument with the agent. He is told that if he cancels his plan he will get only Rs. 50,000/- after deducting all the penalties plus his tax benefit will be forfeited. So, Mr. X decides to continue investing for 3 years so that he can close the plan after the mandatory investment period

End of Year 1: Mr. X invests another 1 lakh to keep the policy active

End of Year 2:
Mr. X invests another 1 lakh to keep the policy active

End of Year 3: Mr. X surrenders his policy in-spite of huge losses

Mr. X is one among the millions of investors who fall under this 97% population that have surrendered their ULIP policies for the reasons explained above.

Why is this number so high these past two years?

Actually speaking this surrender % was 98% at the end of the 2010-2011 financial years. The reason why it is so high now is because ULIPs were being sold in every street corner to unsuspecting investors across India around 2007, 08 and 09. Millions of investors purchased products that don’t suit their needs without understanding the charges & fees. All of them, just like Mr. X is forced to wait 3 years to even come out of the policy in order to salvage some amount of their investment. Anyone who invested during that peak period between 2007-09 would've waited for their 3 year lock-in and started to surrender their policies just like Mr. X.

This is exactly why the past couple of years has seen such a massive landslide surrender of ULIP Policies.

Is IRDA doing anything about this?

From their side, IRDA has brought in some mandatory requirements, trainings etc. for agents who sell insurance products and are trying to bring in more governance into the model. Unfortunately, not only sales-persons but also their regional bosses and everyone up the chain of command are only worried about the number of policies sold and the amount of premium collected and hence are selling as many policies as they can even if it means selling products to people who may surrender it as soon as the lock-in period expires.

What is my advice to prospective ULIP Investors?

Preferably - stay away from them.

If you are absolutely convinced about some ULIP product, check its fees & charges. If it is anything above 5% then you are probably getting yourself into an honey-trap. Ask the agent for a realistic projection of returns and ask him to skip the you will be a Crorepati in 10 years at 25% rate of returns. Tell him that the market is volatile for the past 3 years and you can’t realistically expect 25% returns year on year for the next 10 years. Ask your agent if he can guarantee this 25% returns. He will probably come down to a more realistic number of around 10% returns which is achievable.

What is my advice to current ULIP Investors?

The article Should you Exit your ULIPs Now? is just for you. Please read it.

Some Last Words:

The fusion of insurance and investment results in higher cost and lower risk coverage. For ex: If your agent says that a 1 lakh premium every year (to be paid for 10 years) will give you a 25 lakh insurance coverage, getting a term insurance plan for 25 lakhs and investing the remaining amount (from the 1 lakh) in a combination of good Mutual Funds and Bank FD's will definitely fetch you far better returns that what the ULIP plan your agent is trying to sell you will.

I repeat - For a given amount, the returns from a well-diversified portfolio are higher than the returns received from the insurance products. The charges involved with the ULIPs are significantly higher. These charges have a major say in deciding the premium we pay for the life insurance and the related benefits as well as the returns you get out of your investment.

Don’t put your hard earned money into a product where the agent, his boss and everyone else is making money while your investment value is eroding. Do your homework, be a smart investor and invest only in good products.

Happy Investing!!!

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