On July 23, 2024, during the presentation of the Union Budget, India's Finance Minister announced significant revisions to the capital gains taxation system, with a particular emphasis on real estate transactions. While these changes are designed to lessen the burden on taxpayers, they may present a dual challenge for those looking to sell properties or engage in real estate transactions.
The finance minister has announced an increase in capital gains taxes for both long-term and short-term investments. The proposed budget raises the short-term capital gains tax from 15% to 20%, while introducing a flat rate of 12.5% for long-term capital gains on all financial and non-financial assets. Additionally, the exemption limit for capital gains on specific financial assets will be increased to Rs1.25 lakh per year. From now on, the holding period required to determine whether long-term capital gains or short-term capital gains apply will be 12 months for listed securities.
For unlisted assets, such as property and gold, the holding period will be 24 months. The previous 36-month holding period for certain assets, like real estate investment trusts (REITs), has been eliminated. The new regulations take effect immediately, starting from July 23, 2024. However, properties held before 2001 will be valued at fair market values as of 1st April 2001. To address tax evasion, the finance minister has proposed that income from renting out a house or part of a house by the owner should be taxed under 'income from house property' rather than 'profits and gains of business or profession.' This change aims to prevent claims of excessive expenses to lower taxable rental income. However, it may affect those who are legitimately operating a property rental business.
The recent changes in tax regulations will raise the tax obligations for long-term capital gains from property sales. Previously, the government taxed long-term capital gains from property sales at 20% with indexation benefits, which allowed property owners to adjust their purchase price for inflation, thereby reducing taxable profits. However, according to the Budget documents, the new tax rate for long-term capital gains on property sales will be 12.5% without the indexation benefit. The elimination of the indexation benefit may lead to a higher tax burden on real estate transactions, significantly impacting property sellers. This move is detrimental to short-duration investments.
What is Indexation?
Indexation modifies the purchase price of an asset to account for inflation, thereby reducing taxable profits and tax liabilities. Without this adjustment, taxpayers could face higher taxes even with the lower long-term capital gains rate. Since inflation diminishes the purchasing power of money over time, adjusting the purchase price for inflation lowers the taxable capital gain, potentially leading to reduced tax payments. The government has set 2001-2002 as the base year for the index with a CII of 100. The CII for 2024-2025 stands at 363.
Without the benefit of indexation, taxes are calculated based on the original purchase price without adjusting for inflation. This could lead to a higher taxable capital gain despite the lower long-term capital gains rate. Essentially, while the tax rate is reduced, the taxable amount might be higher due to the absence of inflation adjustment, potentially resulting in increased taxes. For example, if you purchased a property for Rs25 lakhs in 2000 and sold it for Rs1 crore in 2024, the indexed purchase price would have been adjusted for inflation, substantially reducing the taxable gain.
Capital shock
According to the Income Tax Department, typical nominal returns on real estate investments range from 12% to 16% annually. In contrast, the government's cost inflation index shows an inflation rate of only 4-5%. The recent changes in real estate taxation are expected to offer "substantial tax savings" for most taxpayers, according to the I-T department. However, data from Knight Frank and the RBI Housing Price Index present a different picture. The compound annual growth rates (CAGR) for real estate over the past two, five, and ten years have varied between 1% and 7%. Furthermore, the RBI Housing Price Index indicates that while some regions may see high returns, overall market trends are relatively subdued. Given this context, while the revised tax structure may lead to tax savings for those with significant short-term gains, it could result in higher tax liabilities for long-term investors who previously benefited from indexation adjustments.
If a person buys a property for Rs100 and it appreciates at a compound annual growth rate (CAGR) of 5% over two years (from FY23 to FY25), its value would rise to Rs110. After adjusting for inflation using the cost inflation index, the current purchase price is Rs109.6 (calculated as Rs100 × 363/331). Under the old tax structure, the tax liability on this property would be approximately Rs0.1. However, under the new tax regime, this liability increases significantly to around Rs1.3, marking a 1000% increase in tax. If the holding period extends to 20 years, the market value of the property would be Rs265. Inflation adjustment would push the purchase price to Rs321, resulting in a long-term capital loss of Rs55.90. While the old tax regime allowed this loss to be offset against capital gains from other asset classes for up to eight years, the new regime does not allow for this offset. The new tax structure will particularly impact shorter-term investments (less than 5 years) where the annual market price growth is below 10%. Conversely, for investments held for over 10 years or those with an annual appreciation exceeding 10%, the impact of the new regime will be neutral or even slightly beneficial.
Under Section 54EC, individuals can save taxes by investing up to Rs50 lakh of capital gains in specific bonds. Additionally, Section 54 allows for tax exemption on up to Rs10 crore when buying or constructing a new house. However, the new tax structure will not affect end users who reinvest in new properties. Instead, it will impact real estate investors seeking to profit and invest elsewhere. The removal of indexation benefits and changes to reporting rental income will limit the expenses investors can claim, thereby increasing taxable income and reducing overall returns. Consequently, these amendments could affect future returns from real estate investments, potentially deterring investors who buy properties solely for rental income and capital appreciation.
The new tax structure could influence money laundering and underreporting practices. Lower tax rates might facilitate the conversion of unaccounted money into accounted money through real estate transactions. For example, individuals could report a property's purchase price at the stamp duty value and pay the remaining amount in cash to the seller. When they sell the property later, they might declare the full sale price, resulting in a higher reported capital gain. This would mean paying only 12.5% tax on the gain, allowing them to convert unaccounted money into accounted money. Under the previous regime, the 20% tax rate on long-term capital gains (with indexation) acted as a deterrent to such practices. Although it would have imposed a higher tax on conversions, it was beneficial for genuine long-term investors.
Challenging terrain ahead
The elimination of indexation benefits, which adjust the cost basis of assets to account for inflation, could significantly impact the profitability of real estate transactions. This change is expected to deter investors from engaging with assets that now face higher tax rates. Specifically, the removal of indexation benefits could have a particularly adverse effect on individuals planning to sell older properties. For example, selling a property that has been owned for 20 years will become increasingly challenging compared to selling a property that has been owned for only five years.
The tax implications of this policy shift are substantial: older properties will be taxed more heavily due to the absence of indexation adjustments, which could lead to reduced net returns for sellers. This added financial burden may discourage property owners from selling their long-held assets, potentially leading to a decrease in market liquidity.
The broader impact of this change could be quite severe for the real estate sector, which plays a significant role in the economy by generating employment and contributing to economic activity. A slowdown in property transactions could lead to fewer jobs in real estate-related industries and diminish the sector's overall economic contributions. This cascading effect could have ripple consequences throughout the economy, affecting not only those directly involved in real estate but also related industries and employment sectors.
