Real estate taxation: Choosing indexation or not

In the Budget for 2024-25 (Apr-Mar), Finance Minister Nirmala Sitharaman had initially proposed doing away with indexation benefit on real estate for calculation of long -term gains. This came with a carrot of lower tax rate. However, later the proposal was amended to give taxpayers the option to choose between older taxation rates with indexation benefit or new rate without indexations.

Investors can choose to either pay taxes at the rate of 12.5% on the gains made sale of real estate, but without the benefit of indexation, or can pay taxes at a rate of 20% with the benefit of indexation. This option to choose between the two tax rates is applicable for properties bought only before July 23, 2024.

Let us understand these options better, including the implications.

What is indexation?

Indexation means adjusting values such as salaries or prices basis a benchmark. For financial assets, indexation means adjusting the purchase price of an asset to inflation. For instance, if an investor has purchased a property in the year 2000 for Rs 100,000, and if it to be indexed using inflation in India, purchasing the same property will cost an estimated Rs 663,000 in 2024.

Why is it helpful?

When the indexed value of an asset class is taken into consideration at the time of the sale of the asset, the purchase price of the asset is higher on an adjusted basis, and as a result the difference between the purchase price and selling price is lower. This helps in bringing down the profit which is under the tax ambit, as well as the actual taxes that an individual needs to pay.

What happens without indexation?

When an asset class does not have the benefit of indexation, it does not take into account the impact of inflation, which can also be understood as the time value of money. This means that the purchasing power gradually decreases with time, making the same asset higher in value with the passage of time.

Without indexation, it becomes difficult to understand whether the higher price of an asset is inflation-led or other factors.

Particularly in case of real estate, prices can see a dramatic swing based on the developments of mishaps in a given area. Sometimes setting up of a new manufacturing unit or large company in the area can propel demand for that area, leading to a jump in prices. Prices also tend to see an upswing in instances of better connectivity for travel and transport or the development of a tourist hub in the vicinity.

Prices can also sometimes slip, especially in instances such as when an area has seen a jump in crime rates or has been impacted due to a natural calamity. The recent COVID-19 pandemic also contributed to property rates seeing a decline in several metro cities, as demand saw a drop.

Let us understand the differences in profit and taxes with and without indexation.

As the table indicates, the benefit of indexation for real estate helps in lowering the profits, which in turn leads to a lower tax outgo for the investor.

Should everyone opt for indexation?

Whether an investor should opt for the benefit of indexation with a higher tax rate or choose to not avail indexation at a lower tax rate will depend on the gains made in the property. 

Let us understand this with an example:

Two individuals, ABC and XYZ had bought properties in their respective hometowns in two different states for Rs 40,00,000 each in 2010. They are now looking at the sale of these properties and are wondering which tax regime they should opt for.

As evident in this instance, for investor ABC, choosing indexation with a higher tax rate results in a lower tax outgo, even though the gains made by them on the sale of property is significantly higher.

Conclusion

Choosing between the tax options with or without indexation for real estate gains requires careful consideration of your property’s purchase price, sale price, and the overall impact on your tax liability. While the 12.5% tax rate without indexation might seem appealing, the indexation benefit under the 20% rate can significantly reduce taxable profits by accounting for inflation. Investors should calculate the tax implications under both scenarios to make an informed decision. Ultimately, selecting the most tax-efficient option can result in substantial savings, ensuring that your investment returns are optimized and your financial goals are met.