Indexation: How it affects long-term capital gains tax calculations

[] In Budget 2017, several changes in the method for computing long-term capital gains, have been proposed, including a change in the base year for indexation. We examine how this affects the long-term capital gains tax on the sale of a property

Under the present tax laws, a person is taxed on profit from the sale of any immovable asset held as a capital asset, under the head ‘capital gains’. For computing capital gains, the immovable assets are divided in two categories, based on the holding period. Any immovable asset which is held for three years or less, is treated as a short-term capital asset and any profit made on such an immovable asset is included in your regular income and taxed at the slab rate applicable to you. However, any immovable property held for more than three years, is treated as long-term and the profit on such sale is taxed at 20%, plus cess and surcharge. Moreover, the tax payer has the option to invest in another residential house or in capital gains bonds of Rural Electrification Corporation or National Highways Authority of India, in order to save on long-term capital gains taxes. The long term gain on such capital assets, is not just the difference between the net sale price and the cost price. The law has prescribed an elaborate method to compute the long term capital gains. In Budget 2017, several changes in the method to be followed for computing long-term capital gains, have been proposed.

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Holding period: Present and proposed

Presently, the law requires you to hold an immovable property for more than three years, to avail of the concessional rate of tax, as well as to be eligible for tax exemption under Section 54, 54F and 54 EC. The Union Budget 2017-18 has proposed to reduce the holding period requirement from three years to two years. So, any immovable property which is transferred after April 1, 2017, will be treated as long-term, if they have been held for more than 24 months and consequently, entitled to the benefits of concessional tax rate, exemption avenues available and the benefit of indexation. However, this provision may not benefit the industry, as immovable properties are not bought and sold like equity shares and debentures. An average investor does not own more than one house and does not sell the house more than twice or thrice during his life time.

Benefit of indexation for long-term assets and changes proposed

A long-term capital asset gets concessional tax treatment, in more than one way. A holder of a long-term asset, has the benefit of enhancing the cost of the asset for the purpose of computing the taxable capital gains. This is generally known as the benefit of indexation.

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If the asset which you are planning to sell, was acquired by you prior to April 1, 1981, you are given an option to use the market value as on April 1, 1981, for the purpose of computing the capital gains. Presently, the law allows you to take the fair market value of the immovable property as on April 1, 1981, instead of the original cost to you or the person who had actually paid for it, in case you have received the immovable property as a gift or inheritance.

For the fair market value of any immovable property as on April 1, 1981, you need to obtain a valuation certificate from a registered valuer. So, the base year being 1981, has a cost inflation index (CII) value of 100. The government notifies cost inflation index for each year, after taking into account the rate of inflation during the previous year. The CII for the current financial year (FY 2016-17), is 1125.

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Let us understand this with an example. Suppose you had purchased a property for Rs 50,000 in 1965 and you sold the same for Rs 85 lakhs in December 2016. The fair market value of the property was Rs 4 lakhs as on April 1, 1981. So, for the purpose of computation of long-term capital gains, you have the option to substitute Rs 50,000 by Rs 4 lakhs (being the fair market value as on April 1, 1981). The indexed cost of the property, based on the CII of 1125 for the current year, would be Rs 45 lakhs and your taxable long term capital gains would be Rs 40 lakhs, even though, in effect, you have earned a profit of Rs 84.50 lakhs.

The budget for 2017-18 proposes to shift the base year from 1981 to 2001, effective from April 1, 2017. This is an excellent proposal, as it will effectively make all the appreciation in the value of your immovable property, between the date of your purchase till 2001, tax-free, as the fair market value as on April 1, 2001, can be opted as your cost and the index for 2001 shall be 100 and the same process shall be followed for computation of capital gains.

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Since the historical data on appreciation in property is not readily available in the public domain, it is not easy to quantify the benefit to the owners of immovable properties. However, we can compare the increase in the CII over these years and the increase in the Sensex barometer of the prices in the equity market in the country. With a base of 100 for 1981, the CII has taken into account 6.95% inflation on a yearly basis, whereas the Sensex has gone up from 173.79 (as on April 1, 1981) to 28,334 (as on Feb 10, 2017), thus, clocking an annual average rate of 15.20%.

So, effectively, the CII has given you the benefit of enhancing your cost by around 7%, whereas, the actual price appreciation in case of equity is around 15%. The price appreciation in immovable properties may not be that high but the CII definitely has not considered the full impact of inflation during the year.

Nevertheless, the proposal will significantly reduce the tax liability for the owners of immovable properties, who had bought the same prior to April 1, 2001.

(The author is a taxation and home finance expert, with 30 years’ experience)

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Category: Lifestyle

Debora Berti

Università degli Studi di Firenze, IT

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