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Indexation or Not – The Issue

The recent Budget presented by the Government sought to rationalise the Capital Gains tax levied on different asset classes, such as the sale of Real Estate and Debt Mutual funds, by removing the Indexation benefit while calculating the capital gains tax liability that has been applicable for all these years and reducing the LTCG tax rate to 12.5%. This caused a lot of angst, especially among property owners who saw this move as leading to an increase in their tax outflow.

However, after much debate on social media platforms and representations from the various real estate industry stakeholders, the Union government has rolled back its proposal to remove the indexation benefits for calculating LTCG tax. This has become a big relief for real estate investors and industry players. Now taxpayers can select either the new 12.5% LTCG rate ‘without’ indexation or the old 20% rate ‘with’ indexation for properties acquired before July 23, 2024.

So, what exactly is this issue of Indexation all about??

 History of Cost Inflation Index and Capital Gains Taxation in India

Inflation is a silent tax that robs the purchasing power of all citizens while increasing costs. It has even brought down governments and destroyed economies the world over. Protecting citizens from the ravages of inflation is one of the important objectives of central bankers and governments across the world.

To protect against inflation, the Government of India introduced the Cost Inflation Index (CII), which is derived as 75% of the average increase in the Urban Cost Price Index for the previous year. Indexation is a process by which the purchasing power that existed at the point of acquisition of an asset is increased to match its current purchasing power while calculating long-term capital gains (LTCG).

To explain this with an example – If a property bought in 2005 for Rs 1 lakh is being sold now for Rs 5 lakh and applying the indexation benefit if the Cost of the Property increases to Rs 3 lac, LTCG at the rate of 20% would be imposed on just Rs 2 lacs (5 lacs – 3 lacs) which works out to Rs 40,000.

Otherwise, if one chooses not to avail of the indexation benefit, the rate of 12.5% tax will simply be levied on the Rs 4 lakh (5 lacs—1 lacs) as capital gain, which works out to Rs 50,000. Hence, one has the choice of deciding which LTCG option to go for.

Background

In India, the LTCG taxation began in FY 1946-47 to curb the speculative investments in the high inflationary environment of post-WW2. It was removed in 2 years but reintroduced in 1956 based on the recommendations of Prof. Nicholas Kaldor. Since then, it has been constantly tweaked to balance out incentivising investments while augmenting government revenues. The concept of Indexation came out in the Chelliah Committee report, which was released in 1991-1992, wherein the erosion of purchasing power due to inflation was clearly highlighted. This resulted in the introduction of Section 48 of the Income Tax Act, 1961, which provided for the Cost Inflation Index.

The government has long incentivised house properties as a tax-advantageous investment avenue. Gains from any asset can be invested tax-free into housing property; principal amounts on home loans can be set off against 80C (cap of Rs.1.5 lacs), and interest (cap of Rs. 2 lacs per year)  can be set off against salary. Home loans have the lowest cost of funds for Indian individuals, while 30% of rental income is exempt from tax. Housing has attracted a lot of capital, but the industry has long struggled under the weight of unfinished or delayed projects.

In a nutshell, this important provision of indexation is back in place, bringing relief to real estate investors across the board. Going forward, the tax liability will differ on a case-to-case basis, primarily depending on the asset’s holding period and the quantum of appreciation on the asset for those assets purchased before July 23, 2024.

If a property is bought after 23 July 2024 and held for a long term ie 2 years, a 12.5% tax with no indexation will apply.

It remains to be seen if the Finance Ministry also gives any respite to other impacted asset classes, such as Debt Mutual Funds.

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