De-Tax: The HUF route to tax planning

Affluent Indian families often use an HUF structure to plan finances and reduce taxes

An Hindu Undivided Family (HUF) is a separate legal entity under the Income Tax Act which is eligible for a basic income exemption limit of up to ₹2.5 lakh and several deductions, just like an individual.

Under existing laws, the moment an individual (Hindu, Buddhist, Sikh or Jain) is born, he becomes a part of an already existing HUF of his father. Once he marries, another HUF headed by him comes into being.

An HUF comprises the karta (the eldest male member), his wife and his three successive generations, which includes children, grandchildren and great grandchildren. It also includes the wives of the sons, grandsons and great grandsons. But husbands of the daughters, grand daughters and great granddaughters are excluded.

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Simply put, the HUF is another tax paying entity in addition to the individual tax payers in a family. As a result, the family’s tax liability gets reduced.

To start enjoying the tax benefits applicable to an HUF, you need to have a PAN card and a bank account in the name of the HUF. Next, the HUF needs to be endowed with initial capital.

This can come in the form of some ancestral property being bequeathed to the HUF (which must not belong to you). Gifts (cash for instance) can also be received by an HUF from an outsider (HUF non-member) for capital creation. These transfers must be supported by documentary evidence such as a letter stating that a gift is being presented to the HUF.

Let’s now use an example to understand how an HUF can help you save tax. Suppose you fall in the 30 per cent income tax bracket and you own some ancestral property. Now, you sell this property and invest the money in fixed deposits.

If your interest income exceeds ₹10,000 a year, you will have to pay tax on it at your applicable slab rate. On the other hand, if you have an HUF to which the ancestral property can be bequeathed, then as long as the interest income from the fixed deposits (including incomes from other sources) does not exceed the ₹2.5 lakh exemption limit, no tax would have to be paid.

Even otherwise, a lower 10-20 per cent rate would be applicable unless the HUF income exceeds ₹10 lakh, in which case the HUF would fall under the 30 per cent tax bracket.

Beware of clubbing

But using HUFs for tax planning is not as straightforward as it sounds. You cannot transfer a property that you hold in your individual capacity to your HUF simply to avoid paying tax on the rental income.

Under the clubbing provisions of the Income Tax Act, despite the transfer, the rent from the property will still be clubbed with your income and taxed accordingly.

Clubbing provisions will however not apply if some time subsequent to the transfer, the HUF gets partitioned.

In this case, the rent-earning property too will get partitioned among the members and will become an asset of the resultant HUFs. The rent will then be treated as the income of the HUFs and will not attract tax, assuming the HUFs fall under the tax-exempt category.

Likewise, you cannot transfer your fixed deposits to your HUF to avoid paying tax on interest income when it exceeds ₹10,000 a year.

But, there are cases where the clubbing provisions will not apply. Suppose you transfer your shares worth ₹50 lakh to your HUF and it sells these shares for ₹1.5 crore, bringing in a capital gain of ₹1 crore.

Then, if the HUF uses this ₹1 crore to buy property or invest in fixed deposits, the rental or the interest income will be treated as income of the HUF and not taxed. This is because clubbing provisions do not apply in case of income (rent or interest) from income (profit on sale of shares).

Similarly, while the rental income from your property that has been transferred to your HUF will continue to be taxed in your hands, income earned from an asset bought using this rental income will be tax free as long as the total income of the HUF from all sources does not exceed the exemption limit.

However, keep in mind that once you transfer your assets to your HUF, you no longer have exclusive rights over them.

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