You live in a home, you invest in a house. The home you reside in is not an investment simply because you don’t intend selling it in the future. But a second house — one that you plan to rent out and sell for profit at a later date — is indeed an investment. Putting money in a second house has, for long, been a favourite among the country’s moneyed.

It’s big-ticket and, until a few years back, gave great returns. An apartment bought in Mumbai or Chennai in 2000, for instance, would have grown five-to-six fold in value by now — beating inflation and safe investment options, such as bank deposits, by a wide margin.

That’s nice but beware. Real estate is a high-value, risky, and fairly illiquid asset. And like any other investment, past record is no indicator of future performance. In fact, the weak run of real estate over the past few years is testimony to its cyclical nature.

Also, selling property at a time and price of your choosing is easier said than done. So, do your homework before committing money. Besides qualitative aspects such as location and project features (see “Four things to check before you buy”), do weigh in the quantitative factors mentioned below.

Focus on capital appreciation Investing in a second house makes sense only if it can deliver healthy capital appreciation. A good investment thumb-rule is whether you will be able to sell easily for a good price. The returns from real estate should be much more than that on safe investment options such as bank deposits. More the risk, higher should be the return.

The annualised return on bank deposits is 9-10 per cent pre-tax. So, the increase in the capital value of your second house should be such that the annualised return is at least 12-15 per cent pre-tax. Less than that and you may be better off sticking with safer options.

Your second house can also give you rental income. But investing in property for its rent-earning potential is not a bright idea. That’s because rental yields — ratio of rent to value of property — are usually quite low. For instance, a 1,000 sq ft apartment in T Nagar, Chennai, today costs upwards of ₹1 crore but it will fetch a monthly rent of ₹20,000-30,000. At ₹2,40,000 to ₹3,60,000, the annual rent is just around 2.4-3.6 per cent of the capital cost. This would apply to most real estate markets in the country. Deduct maintenance costs and taxes, and the yield falls further.

The rental yield thus clearly compares poorly with the return on safe fixed income instruments. Also, there is no assurance that the house can always be let out; there may be slack periods when there may be no tenants to occupy the house. Rental income supplements capital appreciation and can cover operational expenses, but it should not drive your investment decision.

So, invest in a second house only if you are sure the capital appreciation will compensate for the high risk and more than make up the cost of purchase. Assess the locality and project for potential to deliver such returns.

Typically, investing in a house under construction can give better returns than buying ready-to-occupy property.

That’s because the higher risks, especially delays, associated with under-construction properties could typically mean a lower cost of acquisition. Also, staggered payments in an under-construction house as against up-front payment for a ready-to-occupy property could improve returns in the former.

Go for loan or not? Going for a loan to finance the second house is a decision that should be carefully thought out. Generally, lenders require that you put in at least 20 per cent of the cost of the property as your contribution before the loan is sanctioned. Leverage — opting for debt for the balance — is a double-edged sword.

It can magnify returns on your capital invested when the going is good but exacerbate the pain when the tide turns. Let’s consider two cases — where the property appreciates significantly and another where growth is meagre.

Say, you bought a house in 2004 by investing ₹25 lakh of your own money and then sold it in 2014 for ₹80 lakh. That’s a profit of ₹55 lakh and an annualised return of 12.3 per cent.

What if you invested ₹5 lakh of your own money (20 per cent of ₹25 lakh), borrowed the remaining ₹20 lakh at 10 per cent a year, repaid the loan in equated monthly instalments (EMI) in 10 years and then sold the house for ₹80 lakh? After considering the tax break on interest payment on home loans, the annualised return for an investor in the highest tax slab works out to 14.1 per cent. The return is higher on the leveraged investment because the rate of appreciation of the house property is higher than the cost of the loan.

But if the value of the property in the above case increased to just ₹40 lakh in 2014 from ₹25 lakh in 2004, the loan would have made a poor investment return even worse.

Investing your own money upfront in this case would give an annualised return of only 4.8 per cent. And with a loan on the terms mentioned above, the annualised return would fall further to just 3.3 per cent. The cost of the loan being higher than the growth in the investment came to bite.

So, buy the second house with a loan only if you are confident that the property’s growth potential more than covers the cost of the loan, and still leaves enough to give healthy returns.

Also, if you are taking a loan to finance your real estate investment, find out how much debt you can comfortably service, based on your present and projected income.

When you go for a loan, the importance of deep pockets and holding power cannot be overstated. Real estate being illiquid, it may take quite some time and effort to find a buyer, especially in a tight market situation. Meanwhile, the loan needs to be serviced nonetheless; else, the lender will take over the house.

Compute cost correctly Not factoring all purchase-related costs can lull you into a false sense of complacency and lead to wrong decisions.

While computing your cost of acquisition, take into account not just the price paid to the seller but also the borrowing cost if you finance the purchase with a loan. Besides, registration charges and stamp duties, and cost incurred towards major improvements and renovation should be considered.

Registration charges and stamp duties in some states can be as high as 10 per cent of the guideline value of the property. Based on this comprehensive cost estimate, assess whether the house can deliver healthy returns.

Taxes on house property income When you invest in a second house, don’t forget the taxman. Under the tax rules, one house that you own is considered self-occupied property and does not attract tax.

But houses other than the self-occupied property do not enjoy this benefit. Such properties are deemed let out, even if they are not actually let out on rent. So, be ready to pay tax on the second house you invest in.

The tax is computed on the rental income if the house is let out, or on the notional rental income (according to the municipal valuation rules) if it is not let out. If the actual rental income on a let-out house is less the rent as per municipal valuation, the latter is considered for tax purposes.

This amount, net of municipal taxes paid, is known as the annual value of the property. Thankfully, you get a flat deduction of 30 per cent of the annual value of the property. Besides, you also get deduction of the interest paid on the loan taken to finance the house.

If you invest in an under-construction property, the interest cost until construction is complete is accumulated. This is allowed as tax deduction in five equal annual instalments from the year in which the construction is completed. While in the case of self-occupied properties, the deduction of the interest cost is restricted to ₹2 lakh a year, it is unlimited for houses let out or deemed let out.

So, in the initial years of the loan, when the interest component is high and rental income is low, there could be loss on house property for tax purposes.

This can be set off against other taxable income to reduce overall tax liability. But with time, as rental income rises and the interest cost falls, the situation will reverse — tax will then be payable on income from house property.

Besides the tax break on interest cost, the principal component of the EMI is allowed as deduction under Section 80C up to ₹1.5 lakh a year. This is not allowed on under-construction houses.

Also, as a buyer, you have to be careful if the purchase price of the house is ₹50 lakh or more. In such cases, you have to deduct tax while paying the seller. The tax has to be deducted at 1 per cent of the entire amount paid to the seller, if the payment for the property is ₹50 lakh or more. So, if you buy a property for ₹55 lakh, you need to deduct tax of ₹55,000 (at 1 per cent of ₹55 lakh).

Review your investment regularly and decide whether to stay invested (if there is scope for appreciation) or sell (either because you have reached your targeted return or to cut losses).

Make an efficient sale Plan the sale of the house to get maximum bang for your buck. First, sell the house only after at least three years from acquisition.

This will get you the benefit of lower tax on long-term capital gains — 20 per cent with indexation benefit. Say, you bought a house in 2004 for ₹40 lakh and sold it in 2014 for ₹1 crore, making a capital gain of ₹60 lakh.

But the tax amount is not ₹12 lakh (20 per cent of ₹60 lakh) but just about ₹3.9 lakh. That’s because the purchase cost of ₹40 lakh is marked up to ₹81.12 lakh (₹40 lakh * 939/463) — using the cost inflation indices published every year. This accounts for inflation between 2004 and 2014. On the long-term capital gain of about ₹19 lakh, tax at 20 per cent along with cess at 3 per cent applies.

This tax too can be avoided if you invest the long-term capital gain in another residential house or in specified bonds. The tax break is available to the extent of gains you invest. So, deploy the entire gains to avoid the tax fully.

You can buy another residential house within one year before the sale or within two years after the sale. If you are constructing a house, you get three years after the sale to deploy the gains.

You must hold the new property for at least three years to retain the tax break. The amount can be re-invested in only one residential house in India and cannot be spread over many properties.

If you have not homed in on another property, you can park the gains in a special Capital Gains Accounts Scheme account provided by many banks.

The gains must be deposited in the account before the due date of filing the tax return for the year in which the sale was made, else, the gains become taxable. The funds must be used to buy another property within two years or construct one within three years from the sale. Else, tax postponed earlier will have to be paid after three years.

If you don’t want to buy another property, invest the gains in specified bonds issued by the National Highways Authority of India (NHAI) or Rural Electrification Corporation (REC).

You can deploy upto ₹50 lakh in these bonds, and must do so within six months from the property sale. The bonds have tenure of three years and an interest rate of 6 per cent (currently) paid annually.

Also read: Four things to check before you buy

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