The Realty Markets: An Investment Loophole?

“Don’t wait to buy real estate. Buy real estate and wait”, in our belief, is one of the best quotes we come across whilst thinking of Realty Markets, and quite evidently stands for what it means.

Yet, before we go ahead, this ignites a firestorm of real estate-related questions in our minds.What is Real Estate and why should one care about it? Is it viable in the long run? What are the benefits of investing in Real Estate? What are the prospects of its growth? Is there a provision of paying lesser tax?

As student researchers, we have always been curious to understand and analyse the various factors which influence an investor’s decisions and distinguish them from other day to day decisions.

In this article, we will be delving deep into both the flaws and fortes of realty investments.

To begin with, investing in real estate helps generate a consistent cash flow. A monthly rental income is a great source of passive income. Be it land, residential, commercial or perhaps even industrial property, lucrative investment opportunities always excite. It offers financial security as well.

Let’s come to the better part of why you’re really here.

Loophole Catalogue-01:

Let’s be honest. Nobody likes giving up too much income to the Government in the form of taxes. To reduce tax liabilities, taxpayers seek out tax ‘shelters’. A tax shelter is essentially a legal way to reduce taxable income. Investors use real estate as a tool to build a fortune, mainly due to its generous tax benefits. Real estate offers tax sheltering through depreciation, operating expenses, and long-term capital gains.

To see how a real estate tax shelter works, let’s look at a hypothetical example of a Rs.25,00,000 property that generates Rs.20,000/month in revenue.

The figures listed below are on an annual basis.

Revenue: Rs.2,40,000

Minus repairs/expenses (i.e., maintenance): Rs.96,000 (Rs.8,000/month x 12)

Equals net operating income (NOI): Rs.1,44,000

NOI is the operating profit. There are numerous expenses which can be deducted pertaining to NOI:

Minus mortgage interest: Rs.96,000 (Rs.8,000/month x 12)

Equals net cash flow: Rs.48,000

This is the net amount that will be taxable and not the revenue generated from the property.

Loophole Catalogue-02:

The real estate industry has undergone historical changes in many countries, partly due to political and economic changes. For instance, homeownership in the history of Britain determined whether one would participate in elections or not. Therefore, title deeds were issued with more caution and political motives.

In recent years, there has been a huge paradigm shift in affordable investment projects. From an investor’s perspective, this decade would be the perfect time to pour money into the risky, yet lucrative market.

Loophole Catalogue-03:

Leverage is one of the biggest benefits of pooling your money in real estate. Leverage means borrowing capital to fund your real estate investments. It helps you increase your purchasing power.

For instance, let’s say you buy a house costing 1 crore . You can pay as little as 10-15 lakhs down payment from your savings and take a housing loan to cover the rest of the cost. In this way, though you invest 10-15% of your money, you are the owner of the property. The value of the property will increase over the years and you’ll get a great ROI without investing a lump sum amount in the form of your entire life savings into it.

Loophole Catalogue-04:

Finally, a less risky investment, considered the ‘hidden gem’ in realty investments is a REIT.

A Real Estate Investment Trust (REIT) is a realty investment without getting ownership of the property. In comparison to direct real estate investment, here one can start investing with a low amount and can buy or sell at any time as liquidity is high in comparison to direct real estate investment. In REITs, an investor has an opportunity to invest in direct equity or non-equity REITs. Most REITs are equity (direct) REITs, which own and manage income-producing real estate whereas mortgage (non-equity) REITs lend money to real estate owners and operators either directly through mortgages and loans, or indirectly through the acquisition of mortgage-backed securities. However, if we go by the income tax norms, an investor investing in REITs for the long-term, would be able to get indexation benefit, which is not available in direct real estate investment.

The benefits of a REIT investment include liquidity, diversification, and passive income in the form of high dividends. The potential downsides of a REIT investment include taxes, fees, and market volatility due to interest rate movements or trends in the real estate market.

Loophole Catalogue-05:

This investment forte is extremely lucrative. However, it is quite dormant in India. Property flipping is a western concept where an investor buys an asset and sells it in a short span of time for a profit. This, however, can be risky as there is no guarantee the price of the asset will increase during the short span of time.

The given graph sums up the metrics that go behind constructing a portfolio in the market and factors that play a role in it.

‘To buy or not to buy, that is the question’. Just like every path has a puddle, the realty market is also a double-edged sword, which makes an equivalent cut when turned to the other side.

The Indian Real Estate sector is considered by many to be the most corrupt sector. Currently, this sector is largely unregulated and opaque, with consumers often unable to procure complete information or enforce accountability against builders and developers in absence of effective regulation. This sector has also emerged as a source of black money over the past decades.

Due to the lack of regulation, there are many unethical practices being followed in the real estate sector. Firstly, the home buyer is often a mute signatory to agreements, which are framed by sellers for their advantage, thus lacking transparency. Secondly, the buyer is obligated to pay an exorbitant penalty interest in case of any delay in payments to the seller. The reverse is generally not true. In case there is any delay in the possession of the property, the seller deems it to be due to unforeseeable conditions as mentioned in the agreement even though this may not be the case. Also, the buyer is required to pay an exorbitant price for square feet, while the usable square feet are generally much lower and not mentioned in the agreement.

Tax shelters, REITs, Leveraging, Refinancing and flipping, the list goes on, but we believe you would’ve gotten a fair idea about how these financial techniques help to devise better investment practices.

With numerous reversals in the market, the Covid-19 Pandemic, running inflation, and also a potential recession in the USA, India now offers a solid chance for investors to consider pooling their funds into the realty market. (If not, as early as possible).

Citations:

Srivastav, Ashish Kumar. “Tax Shelters.” WallStreetMojo, 13 Sept. 2022, https://www.wallstreetmojo.com/tax-shelters/

“Loopholes in the Real Estate Sector in India.” Indian Issues, https://imperfectnation.weebly.com/loopholes-in-the-real-estate-sector.html

Manohar, Asit. “How Income Tax Rules Help REIT Investors Earn More in Long Term.” Mint, 25 Sept. 2021, https://www.livemint.com/money/personal-finance/how-income-tax-rules-help-reit-investors-earn-more-in-long-term-11632552245297.html

Chen, James. “What Is Flipping? Definition, How It Works, Types, and Example.” Investopedia, Investopedia, 7 Dec. 2022, https://www.investopedia.com/terms/f/flipping.asp