The problem with Duolingos answer is 'pensilnya' means 'the pensil'. Writing 'Itu pensilnya' as if this means 'That is his pencil' doesn't make sense. Logically it should be 'Itu dia pensil' which directly translated means 'That his pencil'

In this case you are using 'itu' as 'that'. Why couldn't it have been 'that book' in the previous example?

Does adding "nya" onto the end of a noun indicate possession?