How new tax rules are chipping away at real estate's investment appeal

Income from letting out a house or part of a house by the owner will not be charged under 'profits and gains of business or profession'. It will now be taxable under 'income from house property' only.

The amendments to India's tax regulations over the last few years, including the reduction in indexation benefits in the July 2024 Budget, signal a clear shift in the government's approach toward real estate investment.

After the public outcry after the July 2024 Budget, the government allowed investors a choice of claiming indexation benefits with a higher long-term capital gains (LTCG) tax rate of 20 percent, as opposed to a lower rate of 12.5% without indexation. This choice is only for properties purchased before July 23, 2024. If you purchase a property after July 23, 2024, only the new rate of 12.5 percent without indexation will apply.

Over the past few years, there have been multiple amendments to the Income Tax Act that have adversely affected real estate investors. From stricter taxation rules, reduced incentives, and limited deductions, real estate investment has become far less attractive compared to other asset classes now.

Removal of indexation benefit

While the government rolled back the amendment to remove the indexation benefit from a retrospective date, and allowed the property investors who have bought properties before July 23, 2024, to choose between the old (with indexation) and the new rule (without indexation), while calculating LTCG from sale of property.

However, those who invest in properties now i.e. after July 23, 2024, will not be allowed to claim indexation benefit at the time calculating LTCG when they sell the property.

Income from real estate can only be disclosed under ‘Income from House property’

Budget 2024 made another key change. Income from letting out a house or part of a house by the owner will not be charged under 'profits and gains of business or profession'. It will now be taxable under 'income from house property' only.

This measure aims to prevent claims of higher expenses to reduce taxable rental income.

However, it may impact those genuinely running a business of letting out properties.

Capping exemption under ‘Section 54F’

In the 2023 Budget, the government introduced a ceiling of Rs 10 crore on the LTCG tax deduction for reinvestments in residential properties under Section 54F of the Income Tax Act. Previously, there was no maximum limit on the amount that could be reinvested for tax exemption. This new limit became effective from April 1, 2023.

Section 54F allows taxpayers to claim an exemption on LTCG arising from the sale of any long-term capital asset other than real estate, provided the proceeds are invested in a residential house. This provision offers relief from substantial capital gains tax. Before the amendment, many startup founders and individuals with significant stock market gains invested vast sums, often hundreds of crores, in residential properties to save on taxes.

A notable example is Radhakishan Damani, the promoter of DMart. He and his brother Gopikishan Damani purchased a property worth Rs 1,001 crore in Mumbai’s upscale Malabar Hills after their company Avenue Supermarts was listed on the stock exchange, generating massive gains. Additionally, Damani's family and associates made another significant property transaction, buying 28 housing units worth Rs 1,238 crore in Mumbai. These transactions occurred shortly after the 2023 Budget provisions were announced on February 1, 2023 but before the new limits of Rs 10 crore took effect i.e. April 1, 2023.

“The move was anticipated to impact luxury housing sales as it seemed to be a negative for the ultra-luxury housing segment since previously there was no such cap. Earlier, to save on tax from their capital gains, HNIs/ultra-HNIs would mostly re-invest in an ultra-luxury property,” says Anuj Puri, Chairman, Anarock Property Consultants. Hence, “it was thought to be a deterrent to an extent, especially for those who were looking to buy a residential home for investment purpose,” adds Puri.

However, this was not seen to have happened and demand for ultra-luxury homes in the last one year remained robust across cities. “As such the impact remained minimal because more than investors, we have seen people buying such real estate to use them as their primary homes. More than the primary market, I think the impact, if any, could have been on the secondary market sales of the luxury and ultra-luxury homes,” says Puri.

Capping exemption on reinvestment in real estate to save tax

While Section 54F offers a deduction for LTCG from any asset except a residential house, provided the net consideration is reinvested in a residential house, under Section 54, a deduction is available on LTCG from the sale of a residential house if the gains are reinvested in another residential house.

Until 2014, Section 54 allowed tax exemption on capital gains from real estate sales if reinvested in residential properties within a specified period, with no limit on the number of properties. The purchase of a new property had to be made within two years, or a new house had to be constructed within three years. However, the Budget 2014 limited this exemption to reinvestment in a single residential property.

The Finance Act, 2019, further amended Section 54, permitting the exemption to apply to investments in up to two residential properties starting from the Assessment Year 2020-21. This change allowed taxpayers to claim LTCG tax exemption if they sold one house and reinvested the proceeds in two residential properties.

There are two conditions: the LTCG should not exceed Rs 2 crore, and this benefit can only be availed once in a lifetime.

Capping deduction or losses that can be claimed under Income from house property

Another amendment that impacted real estate investors was introduced in the 2017 Budget. This change imposed a cap on the maximum loss that can be claimed from a house property and offset against other sources of income, such as salaries and business income.

Since this amendment, a homeowner can offset losses only up to Rs 2 lakh under the category of 'income from house property.' Previously, there was no such restriction, and investors used to buy properties on loans, with the loan repayment being adjusted against any rental income, allowing the loss to be set off. However, even after the amendment, if the loss exceeds Rs 2 lakh, it can be carried forward for up to eight subsequent years for offsetting against future income. But, even in the subsequent years, the offsetting limit remains the same, which typically restricts the ability to claim the full benefit, as was the case before the amendment.

The impact

Most experts say these changes have and will certainly impact real estate as an investment class, however, they believe these changes will also help end-use homebuyers. “Some of the provisions are designed to curb speculation among investors in property. So, overall, this will help the end-users as the runaway price increases seen in property will probably not be evident so much due to the cool-off of investors who park their money in property,” says Suresh Sadagopan, founder of Ladder7 Financial Advisories.

Sanjeev Govila, Chief Executive Officer, Hum Fauji Initiatives, a financial planning firm, says that these changes will also shift investor focus to financial assets. “Investors would now increasingly look towards financial assets like equities, mutual funds, and bonds, which now offer more competitive post-tax returns compared to real estate,” he says.