How removal of indexation for homeowners may lead to better returns

Real estate

One of the reasons  this year’s budget touched some raw nerves is the simplification of capital gains taxation. The removal of indexation for long term capital gains (LTCG) in property transactions clearly did not go down well with taxpayers.

The government reduced the LTCG tax to 12.5 percent on multiple asset classes including property, gold, gold and silver Exchange-Traded Funds (ETFs), fund of funds (FOF), international funds, and unlisted securities. The holding period for all these assets was also reduced to 24 months (from 36 in some cases), for the gains to be treated as long term.

Normally, such a move would have been welcomed as the investment choices for creating long-term wealth, along with lower taxation, have significantly widened. Investors can now be asset agnostic as taxes will cease to be a source of asset biases. Investment merit would reign supreme and the overall asset quality of investment books will become significantly better.  An investor can reduce his excessive dependence on listed equities for wealth creation.

But what spoilt this near-perfect setting was the removal of indexation benefits for the purpose of calculating  LTCG in property.

Efficiency wins, asset allocation wins

What does this mean for homeowners? It means that the government would no longer insulate property owners from the impact of inflation. Earlier, we could adjust the cost of our property against inflation for the entire holding period. Now, by taking that away, the government made it the responsibility of property owners to ensure that their purchase decisions beat inflation and deliver superior returns. Only then would the lower tax rate be beneficial for them.

Also read: New real estate tax rules: Who gains, who loses; a comprehensive guide

On the contrary, if they overpaid for their property or bought mediocre assets which failed to appreciate, they would still need to pay taxes at the rate of 12.5 percent on the actual gains over their cost of purchase. Clearly, this means that only efficient asset buyers stand to gain in the new system, whereas the old system extended support to those who made bad investment decisions too. But this move is not all that bad for homeowners as it still gives them an option to reinvest their proceeds in another property without paying any LTCG tax.

Up to a limit of Rs 2 crore, a homeowner can reinvest even in two properties the capital gains generated from selling one. Up to a ceiling of Rs 10 crore, he can reinvest the proceeds (capital gains derived from any asset such as gold, unlisted or listed equity shares and so on) in one home property without paying any tax on LTCG.

So, for those reinvesting the proceeds, it is not as bad as it is made out to be. But if the home owner chooses not to reinvest the money in another residential property, he has no inflation protection any more and has to  pay an LTCG tax of 12.5 percent on his actual gains.

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History says lower taxes without indexation is preferred

While the removal of indexation seems unfair, it may not be too bad over the long term. Our past experience of investments  made without indexation benefits have a lesson for us. In 1999, for listed equities, you could either pay an LTCG tax of 20 percent along with indexation benefits, or pay a simple tax of 10 percent on the entire LTCG.

Most of us shifted to the simpler tax regime. But, that’s not the real story. We started viewing equities without wearing the blinkers of indexation. We stopped thinking and obsessing over harvesting tax losses and actually focused on making investment decisions which could deliver returns that beat inflation by a wide margin.

This mindset shift happened because the tax rate was attractive and we could  invest better to take adequate advantage of the same. We should logically look at doing the same in the new LTCG regime. It's actually a great opportunity to become more objective and outcome dependent in home buying. But the public is not in the listening mode. However, this too shall pass. The decision to purchase or sell an asset must now be taken from an asset allocation perspective, with the intention of improving one’s overall asset quality.

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Tax-saving strategy

If one does not wish to reinvest his entire gains in real estate simply for the sake of saving on taxes, the lower LTCG tax should be paid and the reinvestment done in superior assets. Our asset portfolios would improved significantly, and this should deliver superior, inflation-beating returns.

A lower LTCG tax enables capital growth and wealth creation. Anyone seeking to create wealth needs to actively pursue long term capital gains taking advantage of superior asset options at lower tax rates. Gold now becomes a far more stable and serious investment choice with the double benefit of lower LTCG tax and a two-year holding period. Better long-term capital gains can be created from multiple asset classes over a shorter period of time at a lower tax rate.

Once the dust settles on the issue and taxpayers begin to calmly weigh their reinvestment options and investment rationale, they should be able to choose between reinvesting their long term capital gains back into another home property, or paying taxes and moving capital towards better asset choices. They will be able to clearly see the relative merits better. Taxes will cease to be the sole decision driver and the importance of this mindset shift in determining investment outcomes will begin to be better appreciated.