Loan amount used for child’s higher education is tax deductible

You may remember Hemant who I had written about in my article of May 04,2017 published in DNA Money. Hemant had about Rs 50 lakh (cost Rs 35 lakh) in a debt mutual fund (MF) which was earmarked to pay for his daughter’s education in USA. The investment was made four years ago, therefore would be eligible for concessional rate of long-term capital gains tax, and after indexation benefit, the tax payable was coming to only Rs 50,000. I had advised him not to redeem the units himself but to gift  the mutual fund units to his daughter, so that she could redeem the mutual fund units without having to pay any long-term capital gains (LTCG) tax, since she had no other taxable income. Hemant had agreed to implement it.

However, he called me back to check on two things. Firstly, the mutual fund house said transferring MF units to another person (except on death) won’t be possible, and his only option was to redeem the units. I asked him to first dematerialise the units into his demat account after which, he could use the normal Transfer Instruction for Delivery slip to transfer the units to his daughter’s demat account accompanied by a letter announcing the gift which his daughter should accept. That would transfer the units into his daughter’s name. She could then proceed to redeem in the normal course. This way all the tax advantages would be retained in a perfectly legitimate way.

His second clarification was even more interesting. He mentioned that his tax advisor had asked him to take an education loan instead of using the invested money. The argument was that because of the deduction available on the interest paid on the education loan, the tax savings would make the loan much cheaper than the return his daughter would get on the debt MF units. This was the calculation he shared with me. His taxable income this year was likely to be around Rs 54 lakh, which means he would be paying income tax of around Rs 16,23,000. If he took an education loan of Rs 50 lakh from a PSU bank (by giving the security of his house), it was available to him at around 10.50% p.a. which means the interest for the first year would be Rs 5,25,000. The interest was fully deductible and his taxable income would drop to Rs 48.75 lakh (from Rs 54 lakh), on which the tax payable was approx. Rs 13,13,000 leading to a tax saving of Rs 3,10,000 approx. (Rs 16,23,000 less Rs 13,13,000). The actual interest paid on the loan thus came down from Rs 5,25,000 to Rs 2,15,000 because of the tax saving of Rs 3,10,000. Interest of Rs 2,15,000 on a loan of Rs 50,00,000 was an effective cost of only 4.30% p.a.  The tax saving impact was so high simply because the tax deduction bought his income below the threshold of Rs 50 lakh after which he had to pay an income tax surcharge. His daughter could easily pay him back this amount by redeeming the mutual fund units which would be earning her around 7% p.a.

I checked out the figures and agreed that it made a lot of sense.  I could not resist giving him another piece of advice though. Instead of taking an ‘education loan” from a PSU bank at 10.50% as proposed by him, I told him to take a loan against the security of the same property from a private bank which would be available much cheaper at around 9% only (around 1.50% cheaper). Hemant loved the idea but had a doubt. Would he still be eligible for the deduction of the interest paid on this “loan against property” despite it not being styled as an “education loan”?

I assured him that if he could prove that the money from the “loan against property” was used for the purpose of the higher education expenses of his daughter, he would definitely be eligible for the deduction of interest paid on the loan. Hemant was reassured and agreed to take a loan instead of just redeeming the mutual fund units and also to take the cheaper “loan against property” rather than the more expensive “education loan”.  

...& ANALYSIS

• Tax savings would make the loan much cheaper than the return his daughter would get on the debt MF units.
   
• Mutual fund units can be redeemed if gifted to your children as they do not have any taxable income
   
• Instead of ‘education loan from PSU bank, take ’loan against property’ from a private bank on same security
   
• Prove that ‘loan against property’ is being used for child’s higher education to avail interest deduction