With the drop in interest rates on home loan, many borrowers are realizing that they are paying fairly high rates in comparison. At times, the difference between existing rates for new loans and the old rates at which they had borrowed may be as much as 200 basis points or 2%, or more. Such borrowers are, therefore, tempted to take fresh loans at lower interest rates to repay existing loans which bear higher interest rates. Are there any tax consequences of such refinancing of existing loans?
Tax deductibility of interest paid on loans depends upon the purpose for which the loan is utilized. If a loan is utilized to buy a house, the interest is deductible (up to ₹2 lakh, provided the house is not the only house whose annual value is being claimed as exempt) in computing income under the head “income from house property”. If the loan is utilized to buy a car, the interest deductibility of such loan depends upon whether the car is used for a business or profession, or whether it is intended for personal use. If it is for personal use, the interest on the car loan is not tax deductible. If the car is used for business or profession, the interest on the car loan is tax deductible.
Interest on loans taken to fund higher education expenses of children is tax deductible from gross total income. If the loan is utilized to buy personal assets, such as home furniture or home consumer durables or is used to fund personal expenditure such as a holiday, the interest on the loan is not tax deductible. If the loan is used to buy investments, the interest on the loan is deductible against the income derived from such investments (subject to a limit of 20% of such income).
When you refinance an existing loan, the tax deductibility of the interest depends upon the purpose for which the original loan was used, and whether the interest on the original loan was tax deductible. If the interest on the original loan was tax deductible, the interest on the new loan would also be tax deductible in the same manner, provided that there is a direct link between the borrowing of the new loan and the repayment of the old loan.
In the context of loans taken to buy a house, the Central Board of Direct Taxes (CBDT) clarified through a circular issued in 1969. It states that the second borrowing should have been used merely to repay the original loan, and this fact should be proved to the satisfaction of the tax officer. But this principle would apply equally to refinancing of loans taken for the purpose of business (to buy business assets or for other business purposes) or for acquisition of investments or for other purposes.
In situations where the new lending institution directly pays the loan amount to the existing lending institution (which is normally the process), there is clearly a direct link, and one can safely conclude that the new loan has been used only to repay the existing loan. However, in a situations where the new loan is disbursed to the borrower, who then uses it to repay the existing loan, care should be taken to ensure that a direct link is maintained between the receipt of the new loan and the repayment of the old loan.
If the amount of the new loan is more than the existing loan being repaid, the deductibility of interest on the new loan would be the same as that of interest on the existing loan to the extent of the amount utilized for repayment of the existing loan. The deductibility of interest on the balance amount of the loan would depend upon the purpose for which such balance has been used.
When you take a new loan, there would also be processing charges. Are such processing charges deductible for tax purposes? Under tax laws, such processing charges would also be considered as interest, and would accordingly be deductible or not deductible in the same manner as interest on the new loan.
Generally, the lending institution requires the borrower to take a life insurance policy. Many times, the lending institution takes the policy on behalf of the borrower for the term of the loan, and may fund the premium through the loan. Is the interest on such funded life insurance premium deductible? To the extent of the loan used to fund life insurance premium, the interest on the loan may not be deductible for tax purposes, as that part of the loan does not bear the same character as the rest of the loan.
All in all, refinancing of loans is tax neutral, provided care is taken to maintain a link between the new borrowing and repayment of the existing borrowing.
Gautam Nayak is a chartered accountant