In recent times, real estate investments have been finding greater traction, with increasing numbers of investors buying property with intent to sell in future and earn handsome returns. Since real estate transactions involve huge sums of money, taxation pertaining to these transactions is usually a subject matter of debate. In this article, we will look at tax structure with indexation and how it helps lower the tax liability.

Capital gains on sale of property

As an illustration, let us assume a property is bought in 2000 at R10 lakh and sold in 2015 at R50 lakh, the profit in this case is R40 lakh. However, this is a notional profit. The real profit should take into account the effect of inflation on the cost of acquiring the property. This is similar to the difference between the real interest rate (which is nominal interest rate minus the inflation) and nominal interest rate (which any investment pays).

Once the property is sold, the issue that sellers have to grapple with is the tax to be paid on the transaction.

Essentially, the tax liability depends on the nature of the capital gain. If the property is sold within three years of buying it, the profit falls under short-term capital gain (STCG). The profit is added to the income and taxed as per the income tax slab that the seller falls under. Hence, for example, if an investor falls under the tax slab of 30%, the gains will be taxed at 30%.

If the property is sold after three years of buying it, the profit falls under long-term capital gain (LTCG). The tax rate on LTCG is a flat 20% of the profit. Profit is calculated using the indexation method, which greatly reduces the tax liability. Investors are advised to look for the most recent data on tax rate and indexation to ensure right taxes are paid.

What is indexation?

Indexation is rationalisation of the purchase price of the property on the basis of inflation. The new cost is based on the cost inflation index (CII), which is a number that indicates the relative level of inflation in each year. Hence, if the CII doubles in five years, the indexed cost should also be taken as the twice of the original cost. CII is a value determined by the Reserve Bank of India, which publishes it every year to be used for the indexation purpose.

An illustration

Continuing with the earlier example, since the property was held for 15 years, the capital gain falls under the LTCG category. Hence, the indexation can be used to determine the tax liability to the government.

First, one needs to find out the CII data for the years 2000 and 2015. As per the data published by the RBI, the value of CII in 2000 was 389, while the value in 2015 is 1,024. Take the ratio of these two numbers to apply indexation on the original cost.

With this indexation, the original cost of Rs 10 lakh gets indexed to Rs 26.3 lakh. Hence, when the profit is calculated using the new indexed cost, the LTCG is Rs 23.7 lakh. The taxes need to be paid on Rs 23.7 lakh now, not on Rs 40 lakh. Since the tax rate on LTCG is 20% of the  profit, the tax liability will be Rs 4.7 lakh.

At the same time, sellers can also keep track of expenses involved in maintaining the property. These expenses can be used to save tax on property transactions by deducting them from the profit to further reduce the tax liabilities.

EYE ON GAINS:

* If the property is sold within three years of buying it, the profit falls under STCG, where the profit is added
to the income as per the income-tax slab of the seller
* If the property is sold after three years of buying it, the profit falls under LTCG — tax rate is a flat 20% of the profit
* Profit is calculated using the indexation method, which greatly reduces the tax liability
* Investors are advised to look for the most recent data on tax rate and indexation to ensure right taxes are paid

The writer is CEO, BankBazaar.com