This article will explore the tax liability on the tax structure on real estate transactions.
Real estate is a significant part of an investor's pie. It is also a time tested asset, which almost always appreciates except in times of severe economic downtrends, when it's temporarily affected. In fact, buying real estate for investment purposes and selling it later at a higher price has become very common among investors. Banks and other financial institutions (NBFCs or non-banking financial institutions) have also helped in this trend by providing easy loans to investors.
What is confusing for many investors though is the tax structure on these real estate transactions. This article will explore the tax liability on such transactions, also known as capital gain (or loss depending on whether the investor made money on the transaction).
Capital Gain Tax Structure
The income tax rules define gain in two broad categories; namely short term capital gain (STCG) and long term capital gain (LTCG). If investors buy and sell assets within 3 years, this comes under short term capital gain. If investors buy real estate, keep it for more than 3 years and sell, it comes under long term capital gain.
For short term capital gain, the gain from asset is added to the investor's income and taxed as per the income slab they fall under. For example, if an investor falls under the tax slab of 30%, the gain will also be taxed at the rate of 30%.
For long term capital gain, tax calculation involves what is known as indexation. The acquisition cost or cost of acquiring the asset is recalculated based on indexation. Indexation is a concept, which factors inflation in its calculation by using a factor called cost inflation index (CII). The cost inflation index number is published every year by Reserve Bank of India (RBI) and people can use it to find out the taxable gain on the transaction.
A note about Indexation
Suppose you bought 2 acres of land today at the rate of Rs 5 lakhs per acre. This means your purchase price is Rs 10 lakhs. After 5 years, the price goes up to Rs 7 lakhs per acre. If you sell at the end of next 5 years, you will receive 14 lakhs. The holding period return will be 40% or 4 lakhs (Rs 14 lakhs ' Rs 10 lakhs). The question is should you pay taxes on the returns of 4 lakhs. The answer is no.
The price of property will not be considered as Rs 10 lakhs while calculating the gain. It will be taken as more than Rs 10 lakhs by using CII. Hence the investor will have to pay taxes on an amount less than 4 lakhs. Let's see an example.
Rahul bought 10 acres of land at Rs. 3 lakhs per acre on 30th Jan, 2000. He paid 30 lakhs for the property.
Case 1: He sold the property on 30th Apr, 2002 at the rate of Rs 4 lakhs per acre. This means he sold it at Rs 40 lakhs and before 3 years. Hence, short term capital gains will be applicable. In this case, there will be no indexation benefit and Rahul will have to pay tax on the gain which is 10 lakhs (40 lakhs ' 30 lakhs). The gain of 10 lakhs will be added to his regular income and will be taxed as per the tax slab he falls into.
Case 2: He sold the property on 10th Jan, 2004 at the rate of 4.2 lakhs per acre. This means he received Rs 42 lakhs. Moreover, since this is done after 3 years, the gain will be taxed by factoring indexation. Hence the investor will not pay tax on Rs 12 lakhs (Rs 42 lakhs ' Rs 30 lakhs) but an amount lesser than 12 lakhs.
In this case, let's take a look at the CII numbers. Numbers for other years which are not relevant to us have been skipped.
Now to calculate long term capital gain, the acquisition price will not be taken as Rs 30 lakhs, a new figure will be considered, this is also known as indexed cost of acquisition, which factors in CII.
The new price of acquisition = Initial price * (CII for the year sold / CII for the year bought)
This will give 30 lakhs * (463 / 389) = 35.71 lakhs.
The capital gain will be Rs 42 lakhs ' Rs 35.71 lakhs = 6.29 lakhs. This is the amount on which the investor has to pay taxes at the rate of 20%. This means the investor will have to pay an amount of 20% of 6.29 lakhs = 1.25 lakhs.
Note: Investors can deduct any other cost spent on the improvement of the property. This will take tax liability further down. You can also calculate indexed cost of improvement to take it further down.
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