The purchase price of a house is not a cost
Posted Sunday, July 29 2012 at 01:00
Rufus is concerned about the amount of tax deducted from his salary after a pay raise.
He writes: “I still don’t understand the Paye calculations. My gross salary for June was Sh43,365 and for July it was 58,234. The June PAYE was Sh6,000 and some hundreds while that for July is around Sh11,000. Please give me the formula and explain the discrepancies.”
I don’t want to repeat the step-by-step process of calculating Paye. But it is clear that Rufus’ salary has crossed into the “highest income” tax bracket. Thus, any increment he gets is taxed at 30 per cent.
Now, the difference between his July and June salaries is Sh14,869; 30 per cent of this is Sh4,461.
Therefore, even without doing the full tax calculation, it is conceivable that his Paye can increase from “around Sh6,000” to “about Sh11,000”.
On his part, Peter is wondering about “the new tax on rental income”.
He writes: “Suppose I buy a house for Sh5 million in cash – that is no loans – and I start renting it out at Sh30,000 per month, shouldn’t I wait until I have recovered the Sh5 million before making any profit? The way KRA has been explaining it seems to imply that the purchase cost does not come into the calculation. Is that the correct way to do it?”
First, let me clarify that this is not a new tax. It has been around ever since Kenya was born. If you doubt me, take a look at part C of the annual individual income tax return form.
Peter’s question brings out a misconception regarding profit in any line of business. Let me illustrate by changing the situation a little bit.
Suppose that instead of buying a house he had saved the Sh5 million in a fixed deposit account earning 7.2 per cent interest: would KRA be justified to collect tax on the interest?
By the way, 7.2 per cent would bring in the same return as the house – Sh360,000 per year. And it is not a far-fetched rate; my bank is paying up to 11.25 per cent for a Sh50,000 fixed deposit!
In the second scenario where the Sh5 million is sitting in a bank account, it appears reasonable that Peter should pay tax on the interest – after all it is an income and the money that earned it is still available.
But it is the same thing when he buys a house. All he has done is changed his asset from “cash in the bank” to “a house at Mlolongo”, for example.
It still belongs to him since he has not surrendered it to anyone. Therefore, he is not justified to argue that the purchase cost, nay, price, should be recovered in cash before profit can be earned.
Let me reiterate this: the purchase price is not a cost! It is an investment. But if Peter sold the house for, say, Sh6 million, the situation would change and the Sh5 million must be deducted from the selling price to get the profit.