Breaking down the ‘Indexation’ puzzle and how it impacts old property sales

If you’re planning to sell an old property purchased in or after 2001, you might find yourself paying more taxes than before.

Previously, property sellers in India could reduce their tax burden through ‘indexation benefits,’ which adjusted the profit made from selling a property by the inflation rate during the ownership period.

This often led to major tax savings based on how long the property was held. But that won’t be possible any more.

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Properties purchased from 2001 onwards will be subject to a 12.5% long-term capital gains (LTCG) tax upon sale.

It may be noted that the benefit of indexation—adjusting the property’s value to reflect current market conditions—has been removed for properties purchased in or after 2001.

This change could increase the tax burden for many property owners unless they reinvest in a new property, which can still exempt them from paying the LTCG tax.

Mehul Bheda, Partner, Dhruva Advisors, said, “The broader tax impact on investments in non-financial assets such as real estate, gold etc, particularly the reduction in capital gains tax rate to 12.5% and eligibility period to 2 years for long-term assets, represent a mixed bag, balancing positive reforms with the drawback of removing inflation-linked indexation.”

Breaking down the ‘Indexation’ puzzle

Indexation is a method that adjusts the purchase price of an asset, such as property, to account for inflation over time.

This adjusted price is then used to calculate capital gains, which is the profit made from selling the asset. By factoring in inflation, indexation allows the owner to determine the property’s value more accurately.

The government publishes the Cost Inflation Index (CII) each year to measure the rise in prices relative to the base year (2001-2002). To calculate the inflation-adjusted purchase price when selling an asset, you multiply the original purchase price by the CII of the sale year and divide it by the CII of the purchase year. This gives the adjusted purchase price, reflecting inflation.

To establish the current value of an older property, a valuer begins by estimating its worth as of April 1, 2001. This base value is then adjusted for inflation using an index updated annually by the Reserve Bank of India. This adjustment provides the property’s “fair market value” for any year after 2000.

Previously, long-term capital gains from the sale of property were taxed at 20%, but the indexation benefit allowed sellers to reduce their taxable profit. However, the indexation benefit has now been removed.

The budget document said, “With the new rate rationalised to 12.5%, the indexation provided under the second proviso to Section 48 will no longer apply when calculating long-term capital gains. This change affects property, gold, and other unlisted assets. The goal is to simplify the calculation of capital gains for both taxpayers and tax administrators.”

While Finance Minister Nirmala Sitharaman said the changes are intended to lower the tax burden, they may create challenges for individuals selling properties or participating in real estate transactions.

Although the new rate at 12.5% is lower, experts have indicated that it may lead to higher taxes without indexation.

How so?

The elimination of indexation means that a seller of an old property cannot adjust the purchase price for inflation.

Therefore, taxes are now calculated based on the original purchase price without adjusting for inflation, possibly resulting in a higher taxable capital gain despite the lower LTCG rate.

Brokerage firm CLSA has explained this with an example. Assume you purchased a property for Rs 5 crore. CLSA standardised this acquisition cost to 100 and utilised the government’s Cost Inflation Index (CII) to calculate the indexed cost of acquisition under the old system.

They then compared this with the new system, which excludes indexation, to compute the LTCG tax at the reduced rate of 12.5% (previously 20%).

According to the brokerage, under the new system, the LTCG tax burden is higher for shorter holding periods (less than 10 years) and moderate property price appreciation (less than 10% per annum).

On the other hand, for investors holding the property for over 10 years and experiencing robust price appreciation (over 10% per annum), the LTCG tax under the new system would be neutral or slightly beneficial.

Government’s view

The Ministry of Finance highlighted that this change aims to benefit the middle class by streamlining the tax approach.

Nirmala Sitharaman said, “We wanted to simplify the approach to taxation, especially for capital gains. The average taxation has come down. When we say it is 12.5%, it is because we have calculated it for each of the different classes. We have brought it down to 12.5%, which is the lowest in several years, encouraging investment in the market.”

Do experts agree?

However, the elimination of indexation benefits is a significant concern for many real estate investors, particularly those holding properties over the long term.

Without indexation, the taxable capital gain on real estate sales will likely increase, raising the sellers’ tax burden and potentially reducing the net profit from their investments.

Dhruv Agarwala, Group CEO of Housing.com and PropTiger.com, said, “The Finance Minister’s decision to remove the indexation benefit for long-term capital gains (LTCG) tax on real estate marks a significant shift for the sector.”

“While the intention to simplify and rationalise the tax regime is clear, the removal of the indexation benefit, despite the reduction in the LTCG tax rate to 12.5%, could lead to a higher tax burden on real estate transactions,” he noted.

Palka Arora Chopra, Director at Master Capital Services Ltd, expressed concerns that the removal of indexation benefits might negatively impact investor returns and create a short-term bearish outlook for the real estate sector.

Vaibhav Gupta, Partner at Dhruva Advisors, remarked, “Removal of cost indexation on all assets is a very significant change which will impact real estate returns in a big way!”

Nilesh Sharma, President and Executive Director at SAMCO Securities, echoed these sentiments, stating that the change could slow down the resale of residential properties and potentially increase the proportion of cash transactions in real estate deals, which could be counterproductive.

On the other hand, Amit Goyal, Managing Director of India Sotheby’s International Realty, welcomed the reduction of the LTCG tax rate to 12.5%, even with the removal of indexation benefits.

He believes this change will encourage more liquidity in property transactions and align the long-term capital gains tax across different asset classes, which has been a long-standing request from investors.

According to CLSA, this change is unlikely to affect end-users who sell their existing homes to buy new ones. However, it will impact investors who sell property investments to reinvest in other asset classes.

“We believe this new regime will likely negatively affect investors with a holding period of less than 5 years and property price appreciation of less than 10% per annum,” the brokerage noted.