From Business to House Property: Analyzing the Legislative Shift in Rental Income Taxation

[Kavach is a student at NALSAR University of Law.]

The Finance Act (No.2) of 2024 had inserted Explanation 3 to Section 28 of the Income-tax Act 1961 (Act) under the head 'profits and gains from business and profession'. It stipulates that any income from the letting out of residential house or a part thereof by the owner shall be chargeable under the head 'income from house property' and not as business income. The amendment came into effect from 1 April 2025. The amendment is crucial in light of the persistent debates as to the classification of rental income from the letting out of properties by the owner. Confusion had existed as to whether it should be classified as business income or house income or income from other sources. Such classification is significant as it has a bearing upon the specific deductions that can be availed by the assessees. 

As outlined in the memorandum explaining the provisions in the Finance Bill, the intention is to prevent the taxpayers from reducing their tax liability by reporting their rental income as business income instead of house income. The taxpayers generally prefer to classify their rental income as business income and not as house income due to various reasons. In the former, the taxpayer can claim specific deductions in respect of the actual expenses incurred and the depreciation with respect to the property. Additionally, they would not have to pay notional rent if their property is not let out. On the contrary, the house income head only allows for standard deduction of 30% along with deduction in respect of the interest on capital borrowed for acquisition/construction etc. This article undertakes a trenchant review of the amendment in light of the existing jurisprudence surrounding the classification of rental income under the Act. It highlights the potential implications of the amendment going forward. 

Existing Jurisprudence

East India Housing Development Trust v. CIT (East India Housing) is a landmark case dealing with the classification of rental income from letting out of property. It categorically laid down the principle that income from simpliciter/bare letting would be treated as house income. The focus should thus be on the nature of letting out as to whether it is simple or complex. This view has also been cited with approval in several subsequent decisions. Additionally, the court in CIT v. National Storage Private Limited propounded that when the property hired out is complex and the income can be attributed more to the facilities and the services rendered than to the bare letting of the property, it shall be treated as business income. Thus, when the letting is only incidental and subservient to the main business of the assessee, the income derived from letting out the property would not be treated as house income. This is a sound principle as the very letting out of the property would become incomplete if the core services and facilities are not provided. 

Subsequently, the Supreme Court in Karnani Properties Limited v. CIT (Karnani Properties) laid down a four-pronged test to assess whether the rental income can be treated as business income, the test being that the activity of letting out should be undertaken continuously (1) in an organized manner (2) for a set purpose (3) and with a view to earn profit (4). Interestingly, there was active involvement and application of entrepreneurial skills as well on assessee’s part. Relying on these considerations, the SC classified the rental income as business income. 

Section 56(2)(iii) of the Act becomes relevant since the rental incomes can also be treated as other income. The provision deals with the letting out of machinery, plant and furniture along with the buildings wherein both the lettings are inseparable from each other. In such cases, the income from the entire letting would be treated as other income provided that the same is not chargeable as business income. Therefore, rental incomes can be classified under three heads depending upon the nature of letting. Here, the case of Sultan Brothers Private Limited v. CIT is instructive and lays down a three-pronged test to assess the inseparability of the lettings:

1. Was it the intention of the parties in making the lease that the two (building and furniture) should be enjoyed together?

2. Was it the intention of the parties that the effect of two lettings be practically of one letting?

3. Would one lease have been accepted alone without the other?

   
   

The court held that if the answer to the first and the second questions is in the affirmative and to the third in the negative, the lettings are inseparable and the income therefrom should be treated as other income. The court ruled that the real test is whether one can be taken without the other and not whether the lettings are primary or incidental. In this case, the lettings were inseparable. The court thus treated the entire income as other income. The ruling is authoritative as the letting of building cannot be separated from the letting of plant, machinery and furniture. They necessarily accompany each other. Therefore, the phrase “lets on hire machinery, plant or furniture belonging to him and also buildings” (emphasis supplied) used in Section 56(2)(iii) of the Act cannot be read to mean that the letting of the building is secondary. Such a literal reading of the provision would lead to absurd results. 

The Universal Plast Limited v. Commissioner of Income Tax case throws further light on the complexity of the categorization of rental income. Here, the machinery was leased out by the company for certain time in order to not keep it idle owing to the halt in operations. The company had no intention to resume business and wanted to wrap it for good. Consequently, the rental income was treated as house income. This case highlights the importance of deciphering the intention of the owner while leasing out the property. There cannot be any straightjacketed formula to categorize the rental incomes one way or the other as is sought to be done by way of the impugned amendment. 

This can be tied with the case of Karanpura Development Company Limited v. Commissioner of Income Tax, West Bengal, which held that the objects of the company as laid down in the memorandum should also be kept in mind while interpreting the nature of activities of the assessee and the operations in relation to them. This case was relied upon by the Supreme Court in M/S Chennai Properties and Invest Limited v. Commissioner of Income Tax (Chennai Properties) to treat the rental income as business income since the main object of the assessee company was to acquire the properties in the city of Madras and let them out. It thus overruled the Madras High Court’s decision by distinguishing the ruling in the East India Housing case on the ground that the object of the company in that case was to develop the landed properties into markets and not to lease them. 

Subsequently, the case of Keyaram Hotels Private Limited v. ACIT (Keyaram Hotels) was also reconsidered by the Income Tax Appellate Tribunal (ITAT), Chennai in light of the law laid down by the Supreme Court in the Chennai Properties case. In the Keyaram Hotels case, the Madras High Court had relied on its own ruling (now overruled) in Chennai Properties case to treat the rental income as House Income. However, the ITAT rightly treated the same as business income since the assessee also maintained a common area and meeting hall, provided security etc. in addition to letting out the property. These activities were carried on in a systematic and regular manner thereby satisfying the test laid down in the Karnani Properties case. 

The Amendment: Necessary or Forced?

Having laid down the existing jurisprudence on the various tests relevant for the classification of rental income, it is pertinent to analyze the impugned amendment in this backdrop. It is clear that the mere relation of an income with immovable property is not sufficient for the assessment thereof as house income. Instead, the primary objective of the assessee in exploiting the property has to be looked at. The income shall be treated as house income if leasing out is the primary intention. However, it shall be classified as business income if the object was to exploit the property by way of complex commercial activities. 

Unfortunately, the impugned amendment ignores the rich jurisprudence on the subject matter by a mere legislative fiat. While it is true that certainty is one of the four canons of taxation, it should not come at the cost of a balanced decision based on the facts and circumstances peculiar to each case. The very nature of rental income from letting out properties is such as to require a thorough examination of the facts. As argued before, blanket treatment of rental income as house income deprives the assessees of several deductions available for business income. The amendment would have a significant impact on the rental housing businesses leading to shortfall in affordable housing units in urban areas. 

Importantly, the amendment seeks to impose tax on rental income based on the nature of asset rather than business motive. An unnecessary distinction is created between residential and commercial properties thereby making it open to a potential challenge under Article 14 of the Constitution. The implication being that the income from residential property would be taxable as house income whereas the income from commercial property would be taxable as business income. The amendment does not simplify the tax assessment but merely shifts the focus from the bare/composite letting dichotomy to that between residential and commercial properties. The characterization of the nature of properties is an equally, if not more, arduous task. A thing cannot by its very nature be a commercial asset. An asset becomes commercial only when used in connection with business. The nebulous distinction made between residential and commercial properties has the potential to give rise to multiple tax litigations thereby violating the canon of economy under taxation law.

The impugned amendment would discourage both institutional and individual investment in the residential housing sector. The individual house owners would be burdened with additional compliances by being obligated to separately report incomes arising from the residential and commercial properties. The amendment, though purporting to simplify tax administration, has disastrous consequences and also violates several basic tenets of tax by focusing on asset type rather than the business motive. As mentioned above, it would have various spillover effects over different areas of the economy and impact the taxpayers in a significant way. 

Conclusion

Identification of business purpose is one of the fundamental requirements to attract the incidence of tax on rental income irrespective of the nature of the asset. As seen before in the Universal Plast case, even a commercial asset can become a regular asset if the intention is to wrap up the business for good. The article argues for the continuance of the current judicial framework which calls for looking at each case from a businessman’s point of view to check the owner’s intention behind leasing the asset. The amendment does not achieve the purported aims but rather disadvantages the house owners wanting to commercially exploit their properties.