“The best way to create wealth is to borrow money and invest in property. You are actually creating wealth on money borrowed at attractive rates. And there are good tax breaks, too, as a topping,” said Ajay, a client of mine.
It did sound logical and I decided to find out.
Let us say Ajay borrows Rs 50 lakh at a fixed rate of 11% for a 20-year term and invests it in a property, paying an EMI of Rs 51,610.
Ajay can let it out on rent and claim full deduction of interest (there is no restriction of Rs 1.5 lakh for tax deduction purposes, in case of rented property) from his property income. If that shows a loss, he could deduct that from his salary income.
Ajay lets out the property and gets a 4% return, post society charges and property taxes. I am also assuming a 5% real increase in the rent year-on-year (after society charges, brokerage & property taxes). The property value is assumed to increase by 8%, over the 20-year period. Even the savings in taxes are invested back.
But why do I assume just 4% return as rent, one might ask. If I am not wrong, for good residential properties, the return can go up to 6% before society charges, property taxes, property maintenance (interior improvement like painting, furniture & fittings etc, from time to time ), brokerage charges and major repair charges.
Also, the property may not be occupied without a break for the entire 20-year period. It is hence fair to assume a 4% return, after these expenses.
But, what about the 8% increase in property rates? As Ajay told me, his current home has almost doubled in two years.
True, property rates have been on the upswing in past 3-4 years. But, what has happened in the recent past cannot possibly be replicated over the long-term.
The reason — when property prices go up, there should be buyers at those prices. Even assuming people want to, servicing loans becomes difficult, especially when the interest rate are in double digits. Hence, there is a built-in speed breaker, as an overwhelming percentage of property is bought with loans.
The net rent in the first year would be Rs 2 lakh for Ajay. To arrive at his income from property, he can deduct property taxes and a 30% deduction as expenses from this. His interest in the first year would be Rs 5,46,396.
Hence there will be a net loss on the property to the tune of Rs.4,06,396, which can be deducted from the gross taxable income. The effective savings on tax for a person in the highest IT bracket of 33.99% is Rs 1,38,175.
However, when a person takes a home loan, that amount is his exposed risk. Hence, it is imperative that he take a risk cover to that extent. The cost of a term insurance of Rs 50 lakh sum assured, would be Rs 18,000 p.a. (here I advise taking two term insurance policies of Rs 25 lakh each for 14 years and 20 years, respectively).
The principal comes down to Rs 25 lakh only in the 15th year, after which there will be just a Rs 25 lakh cover and Rs 9,000 to pay as premium. That is a cost we need to factor in while making property investments.
At the end of 20 years, the property value is expected to be Rs 2.33 crore. Assuming that one wants to cash out at the end of the 20th year, there will be capital gains tax to pay.
It can be calculated with indexation and without indexation. Using past indexation numbers, the value of property after indexation comes to Rs 1.85 crore.
The profit is hence Rs 48 lakh. The tax to be paid is 20% on this, i.e., Rs.9.57 lakh. Net realised amount from the home is Rs 2.23 crore
The rental income and tax savings less the risk cover, if invested at 8% and 12%, yields Rs 1.78 crore and Rs 2.85 crore, respectively . The total proceeds are hence Rs 4.01 crore and Rs 5.08 crore, respectively. That is a pretty packet, by itself.
If Ajay had been investing the EMIs he was paying in mutual funds/ equity on a monthly basis, after 20 years he would have a cool Rs 5 crore. What he could get from property with 8% returns of surpluses is 24.6% less than what he could have made from MF/ equity.
However, if he invests in property and invests the proceeds from rent and tax breaks after insurance, he would come to a figure of Rs 5.08 crore.
This is marginally more that what he could get from investment in equity/ mutual funds. But there are much less hassles in MF/ equity that are endemic to property.
In property, there is a concentration risk, it is illiquid and the loanee is exposed to interest rate risks, etc. This straight away douses the blazing arguments of creating wealth on borrowed money and saving on tax. Also, there is a very clear case of paying ones’ taxes without fretting about it. After all, it is good for you, as we just saw.
The writer is a practising certified financial planner of Ladder7 Financial Advisories. He can be reached at ladder7@gmail.com.
