Income from Salaries and House Property notes — Unit 2

Under the Income Tax Act, you cannot just add up all the money a person receives. Section 14 mandates that all income must be classified and computed under five specific 'Heads of Income'. Each head has its own unique rules for calculation and deductions.

• 1. Salaries
• 2. Income from House Property
• 3. Profits and Gains of Business or Profession (PGBP)
• 4. Capital Gains
• 5. Income from Other Sources

This unit focuses on the first two heads.

For any payment to be taxed under the head 'Salaries', a fundamental relationship must exist.

⇒The Core Requirement: Employer-Employee Relationship

There MUST exist a Master-Servant or Employer-Employee relationship between the payer and the payee. If this relationship is absent, the income cannot be taxed as salary.

• Example (Director): The salary received by a Managing Director is 'Salary' because they are an employee. But fees received by an Independent Director for attending board meetings is taxed under 'Other Sources' (no master-servant relationship).
• Example (MP/MLA): Salary received by a Member of Parliament is NOT taxed under 'Salaries' because an MP is not an employee of the government; they are elected representatives. It is taxed under 'Other Sources'.
• Example (Guest Lecturer): Remuneration to a visiting guest lecturer is taxed under 'Profession' or 'Other Sources', not Salary.

⇒Basis of Charge (Section 15)

Salary is taxable on a 'Due or Receipt' basis, whichever is earlier.

• If your employer owes you salary but hasn't paid it yet, it is still taxable this year (Due basis).
• If you take an advance salary for the next 3 months, it becomes taxable immediately this year (Receipt basis).

The term 'Salary' is defined very broadly in the Act. It includes:

• Wages, Basic Salary, Advance Salary, Arrears of Salary.
• Any Annuity or Pension.
• Any Gratuity.
• Any fees, commissions, perquisites, or profits in lieu of or in addition to any salary.
• Leave Encashment (payment for unavailed leaves).
• Employer's contribution to a Recognized Provident Fund (in excess of 12% of salary).

We will now break down the complex parts: Allowances and Perquisites.

An allowance is a fixed monetary amount paid by the employer to the employee (over and above basic salary) to meet certain specific expenses.

⇒Classification of Allowances

• 1. Fully Taxable Allowances: Added directly to income. (e.g., Dearness Allowance (DA), City Compensatory Allowance (CCA), Medical Allowance, Tiffin/Lunch Allowance, Overtime Allowance).
• 2. Fully Exempt Allowances: Not taxed at all. (e.g., Allowances paid to High Court/Supreme Court Judges, Allowances paid by UNO).
• 3. Partially Exempt Allowances: A specific portion is exempt, and the rest is taxable. This is the most complex category.

⇒House Rent Allowance (HRA) - Sec 10(13A)

Given to meet the cost of a rented house. The minimum of the following 3 amounts is EXEMPT from tax (the rest is taxable):

• 1. Actual HRA received.
• 2. Rent paid minus 10% of salary.
• 3. 50% of salary (if living in Metro: Delhi, Mumbai, Chennai, Kolkata) OR 40% of salary (for Non-Metros).

(Note: 'Salary' for HRA means Basic Pay + DA (if part of retirement benefits) + Commission based on fixed % of turnover). If the employee lives in their own house (pays zero rent), the entire HRA is fully taxable.

⇒Special Allowances (Sec 10(14))

• Children Education Allowance: Exempt up to ₹100 per month per child (maximum 2 children).
• Hostel Expenditure Allowance: Exempt up to ₹300 per month per child (maximum 2 children).
• Transport Allowance: Generally fully taxable now, EXCEPT for blind/orthopedically handicapped employees (exempt up to ₹3,200 per month).
• Official duty allowances: (Travelling, Daily, Conveyance, Uniform allowance) - Exempt to the extent the amount is actually spent for official purposes.

While an allowance is a fixed cash payment, a 'Perquisite' (or Perk) is a benefit or facility provided by the employer to the employee in kind (free of cost or at a concessional rate).

⇒Common Taxable Perquisites

• Rent-Free Accommodation (RFA): If the employer provides a free house. The value of this perk is added to the salary. (Calculation depends on whether it's Govt/Private and owned/leased).
• Motor Car Facility: If the employer provides a car for personal or mixed use. (Calculation depends on engine cc and who pays for fuel).
• Free Education: If the employer pays the school fees of the employee's children.
• Interest-Free Loans: The interest saved by the employee (compared to SBI rates) is a taxable perquisite.
• Domestic Servants: Sweepers, gardeners, or watchmen provided by the employer.

⇒Exempt Perquisites (Not Taxable)

• Medical facilities in a hospital maintained by the employer.
• Free meals provided during office hours (up to ₹50 per meal).
• Laptops/Computers given to the employee for use.
• Employer's contribution to staff group insurance.

A PF is a retirement benefit scheme. Both employee and employer contribute a portion of the salary to a trust, which earns interest and is paid out at retirement. Tax treatment depends on the type of PF:

⇒Statutory Provident Fund (SPF)

Maintained by Government and Semi-Govt organizations. Employer's contribution and interest are fully exempt.

⇒Recognized Provident Fund (RPF)

Maintained by private organizations and recognized by the Commissioner of Income Tax. This is the most tested in exams:

• Employer's Contribution: Exempt up to 12% of Salary. Anything above 12% is taxable.
• Interest Credited: Exempt up to 9.5% per annum. Interest above 9.5% is taxable.
• (Note: Salary here means Basic + DA (retirement) + fixed % commission).

⇒Unrecognized Provident Fund (URPF)

Employer's contribution and interest are NOT taxed every year. But when the lump sum is withdrawn at retirement, the employer's share and interest become fully taxable as 'Profits in lieu of salary'.

After summing up Basic Pay, Allowances, Perquisites, and PF (This total is called Gross Salary), the law allows three specific deductions under Section 16 to arrive at the Net Taxable Salary.

• 1. Standard Deduction (Sec 16(ia)): A flat, unconditional deduction of ₹50,000 is allowed to all salaried employees. (If gross salary is less than 50k, the deduction is limited to the salary amount).
• 2. Entertainment Allowance (Sec 16(ii)): Deduction is available ONLY to Government employees. The deduction is the lowest of: (a) Actual allowance received, (b) 20% of Basic Salary, or (c) Maximum ₹5,000. (Private employees get zero deduction for this).
• 3. Professional Tax (Sec 16(iii)): Any tax on employment levied by a State Government is fully deductible in the year it is actually paid by the employee.

This head taxes the earning capacity of real estate. Interestingly, it taxes the 'inherent capacity' of the property to earn income, not just the actual rent received.

⇒Basis of Charge (Section 22)

The Annual Value of property consisting of any buildings or lands appurtenant thereto, of which the assessee is the owner, shall be chargeable to income tax under the head 'Income from House Property'.

⇒Three Essential Conditions for Taxability

• 1. Must be a Building or Land Appurtenant: Vacant land is NOT taxed here. It must have a structure (house, shop, godown). Income from purely vacant land is taxed under 'Other Sources' or 'Business'.
• 2. Assessee must be the Owner: Only the owner pays tax under this head. If a tenant sublets the house to someone else, the subletting income is taxed under 'Other Sources' (because the tenant is not the owner).
• 3. Property not used for own business: If the owner uses the building for their own business or profession, the income is not taxed here (it's absorbed into business income).

For tax calculations, a house is classified into three categories based on its use:

⇒1. Let Out Property (LOP)

A house that is actually rented out to a tenant for the whole or part of the year. The rent received forms the basis of calculation.

⇒2. Self-Occupied Property (SOP)

A house occupied by the owner for their own residence. The law provides a huge benefit here: The Annual Value of up to TWO self-occupied houses is taken as NIL (Zero). You don't pay tax on the house you live in.

⇒3. Deemed Let Out Property (DLOP)

If an assessee owns MORE than two houses for self-occupation, the law only exempts two. The third (and fourth, fifth, etc.) house, even if kept locked and empty, will be legally assumed to be rented out ('Deemed Let Out'). The owner will have to pay tax on the imaginary rent it could have earned.

The first step in calculating house property income is finding the GAV. It is a highly technical 3-step calculation.

⇒The Four Values you need:

• Municipal Value (MV): The value assigned by the local municipality.
• Fair Rent (FR): The rent a similar property in the same locality would fetch.
• Standard Rent (SR): The maximum rent legally allowed under the Rent Control Act.
• Actual Rent Received (ARR): The actual rent the tenant is paying.

⇒The 3-Step Formula for GAV

• Step 1: Compare Municipal Value (MV) and Fair Rent (FR). Take the HIGHER amount.
• Step 2: Compare the result of Step 1 with the Standard Rent (SR). Take the LOWER amount. This result is called the Expected Rent (ER). (In simple terms: ER is the higher of MV or FR, but restricted to SR).
• Step 3: Compare the Expected Rent (ER) with the Actual Rent Received (ARR). The HIGHER of the two is your Gross Annual Value (GAV).

Once you have the Gross Annual Value (GAV), you must deduct municipal taxes to find the Net Annual Value.

⇒Deduction of Municipal Taxes

Municipal taxes (property tax, water tax, sewerage tax levied by the local authority) can be deducted from the GAV, but subject to TWO strict conditions:

• 1. Actually Paid: The taxes must be actually paid during the previous year. (Outstanding or unpaid taxes are not deductible).
• 2. Paid by the Owner: The taxes must be paid by the owner, not by the tenant. If the lease says the tenant pays the property tax, the owner gets no deduction.

⇒Formula

Net Annual Value (NAV) = Gross Annual Value (GAV) - Municipal Taxes paid by owner.

From the Net Annual Value (NAV), the Act allows only two specific deductions under Section 24 to arrive at the final Taxable Income from House Property. (No other expenses like repair, insurance, or electricity are allowed).

⇒1. Standard Deduction (Sec 24(a))

A flat 30% of the NAV is allowed as a deduction to cover all expenses (repairs, collection charges, insurance). It is a blanket deduction. Even if the owner spent ₹0 on repairs, they still get a 30% deduction. If they spent 80% of rent on repairs, they STILL only get 30%.

⇒2. Interest on Borrowed Capital (Sec 24(b))

If the owner took a loan to purchase, construct, repair, or reconstruct the house, the interest paid on that loan is deductible.

• For Let Out Property (LOP): The ENTIRE interest amount is fully deductible without any maximum limit.
• For Self-Occupied Property (SOP): The maximum deduction is restricted to ₹2,00,000 per year (provided the loan was taken after 01-04-1999 for acquisition/construction and completed within 5 years). If the loan is for repairs, the limit is only ₹30,000.

How does the calculation work for the house you live in?

• Gross Annual Value: NIL (By law).
• Less Municipal Taxes: Not allowed (because GAV is nil).
• Net Annual Value (NAV): NIL.
• Less Standard Deduction (30% of NAV): NIL (30% of 0 is 0).
• Less Interest on Loan (Sec 24(b)): Allowed up to ₹2,00,000.

⇒Summary of Master Concepts

• Salary: Requires employer-employee relationship. Taxed on due/receipt basis.
• HRA: Exemption is minimum of: Actual, Rent - 10% salary, or 50%/40% salary.
• RPF: Employer contribution exempt up to 12%. Interest exempt up to 9.5%.
• House Property Basis: Taxes the inherent capacity of the building/land appurtenant owned by assessee.
• GAV Calculation: Higher of MV/FR (restricted to SR), compared with Actual Rent.
• Sec 24 Deductions: 30% Standard Deduction + Interest on Loan (max 2L for SOP).

⇒University Exam Tips for this Unit (Premium Advice)

• The GAV Calculation: You will definitely get a practical numerical problem to calculate GAV and Income from House Property. Memorize the 3-step ER/ARR formula. Remember to deduct municipal taxes ONLY if 'paid by owner'.
• SOP Loss: Emphasize in theory answers that a Self-Occupied Property can only generate a loss (due to interest deduction on a Nil NAV), which acts as a powerful tax-saving tool.
• Allowances vs Perquisites: Be clear on the difference. Allowance = Cash. Perquisite = Facility in kind (like a car or house). HRA is an allowance, Rent-Free Accommodation is a perquisite.