Correct, it's the potential rental income the property would earn, if it was rented out.

Because you live in it and don't pay rent, the tax department deems that the potential rental income you would have otherwise earned is valid "income" and thus taxable.

It's a concept that homeowners from other countries find difficult to grasp.

But on the other hand, any mortgage interest on the property can be deducted (which eg New Zealand doesn't allow).

So a lot of Swiss try and balance the extra Eigenmietwert income with the deduction of their mortgage interest. If the mortgage interest is reducing, you borrow some extra money to renovate the home and increase the mortgage interest again. System works fine if you have a perpetual mortgage.

But you get penalised for home ownership if you ever pay the mortgage off and own the house outright.

To prevent this penalty from hitting most Swiss, the Swiss simply plan to never pay off their home, and when they die the children inherit the mortgage. Which creates interesting situations if suddenly the children cannot afford to pay the mortgage interest, and thus cannot afford to live in their family home - I've heard cases where this actually occurred!