A rental house on mortgage is a loss maker
The Sunday Nation
Nairobi,
05 August 2012
After reading last week’s article on how to calculate the tax on rental income, Ng’ethe asks a follow up question: “Does the argument…change if you do not own the property because you are paying a mortgage for it?”
The simple answer is yes! If you are paying a mortgage for the house, then the interest charged is an operating cost. But remember that the principal component is NOT a cost. Thus, for proper accounting, the house buyer needs to get a statement from the financier showing the distribution of the instalments between principal and interest.
To illustrate, suppose the Sh5-million-house in last week’s example was bought through a fifteen year mortgage at 18 per cent per annum. If the instalments are calculated on the common “reducing balance” method, the buyer would be required to pay Sh80,521 per month.
In the first month of the repayments, the interest portion is Sh75,000. This reduces to Sh74,917 in the second month and continues the downward trend up to Sh74,019 by the twelfth month of the first year.
Let us simplify matters a little bit and assume that the payments start in the month of January. Then, by December, the total interest paid is about Sh820,000. Assuming further that the house was rented at the Sh30,000 per month from January to December, the annual rent collected comes to Sh360,000.
Clearly, this house is a loss-maker! The owner has lost about Sh460,000 even before we even add other costs like repairs, land rent and land rates.
But does this mean that the buyer will not pay any taxes?
Well, if he has no other source of income, he wouldn’t pay any tax. But when you think about it, if he has no income, then he cannot afford the mortgage! He has to explain where the Sh80,521 is coming from. After all, no bank will give you a loan if you cannot prove that you are able to pay
May be he is employed and is therefore paying PAYE. In that case, it would be best for him to fill out the annual tax return form at the end of the year showing his salary income and rental loss. Obviously, it will turn out that the PAYE deducted was higher than the tax due. That is, he will qualify for a refund from KRA!
How much should he expect? Well, given that his income is already in the highest tax bracket, the Sh460,000 would have attracted 30 per cent tax; that is Sh138,000. But the Sh460,000 is a loss and as such, it carries a negative sign in front. Therefore, the Sh138,000 is also negative amount, meaning it is a refund.
This loss-making situation (and the corresponding tax refund) will persist until the year when the rent will be higher than the mortgage interest. Remember that in the “reducing balance” method, the interest portion reduces in every succeeding month. Rents also go up with time. Therefore, the answer is not a straightforward matter. We shall tackle it in a future article.
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