How landlords can pay loans with ease

After reading last week’s article on how to avoid paying rental income tax legally, several readers have asked me why I was not subtracting the whole instalment amount before calculating the tax due. The answer to that is that one part of the money paid to the bank goes to settle the principal amount and the other towards the interest.

The principal amount is not an expense: It is an investment. To understand this more clearly, suppose you purchased the house for cash; that is, you used you own savings to pay the Sh10 million in full without borrowing anything. Would you treat that payment as an expense?

Of course not! It is an investment. And in such a case, almost the full rent collected would be your profit. Perhaps the only expenses you would incur would be for land rates, repairs etc. These are usually quite small, especially in the case of a new house.

Therefore, you would be better off to stay in the Residential Rent Tax regime and pay 10 per cent of the rent collected as the final tax. If you transferred to the normal income tax, you would have to pay about 30 per cent.

OVER SUPPLY

Another example: suppose you have just Sh1.6 million and your rich aunt lends you the balance (Sh8.4 million) for five years at no interest. Your monthly instalment would be Sh140,000 per month – the same as what you would be paying the bank for the Sh10 million loan (see last week’s article).

The only difference here is that you are not paying any interest. Therefore again, almost all of the Sh75,000 rent is your profit and you must pay tax on it! So now you will find yourself in the situation where your asset is making a profit, but it doesn’t generate enough cash to even pay the 10pc tax!

Incidentally, this is the kind of arrangement that people find themselves in when they borrow under the Sharia Banking Rules. So think carefully before you rush to sign up.

The question that many are struggling with is this: why is it not possible to collect enough rent to pay the mortgage instalment?  In other words; what needs to change for this to happen?

The answer comes from the calculation we did two weeks ago. If you borrow Sh10 million at 15 per cent per annum, the interest amount in the first month is Sh125,000. This alone is way higher than the rent you are likely to get for such a house – Sh75,000.

So, what interest rate should be applied to bring down the monthly instalment from Sh140,000 to Sh75,000? The answer is: 4.2 per cent. At that level, the monthly payment for a 15-year loan comes to Sh74,975.

The challenge is that there are too many Sh10 million houses so rent cannot go any higher. On the other side of the scale, money is in short supply and banks have to pay way above 4.5 per cent for large deposits. Closing this gap is not an easy job and I don’t envy the Cabinet Secretary for Treasury.