From simplicity to fairness: Indexation benefit for property restored. But is it enough?

The recent amendment to the Finance Bill, which offers the choice of a 20% LTCG tax with indexation or a 12.5% tax without indexation for property deals before 23 July, is a welcome change. 

This move marks a U-turn from the finance minister's announcement in the Budget 2024 to remove indexation. However, the amendment should extend to future deals as well. Here's why:

Amount of invested capital

Consider Mr A, who buys a property for ₹50 lakh, and Mr B, who buys one for ₹1 crore. After six years, both sell their properties for an additional ₹50 lakhs. Mr A sells his property for ₹1 crore, clocking a 100% return on investment (RoI), while Mr B sells for ₹1.5 crore, making a 50% return. 

Is it fair to tax the same amount for different RoIs over the long term? In such cases, indexation offers a fair basis to calculate LTCG.

Investment period

Suppose Mr A and B acquired an asset for ₹1 crore in the same year but sold it after a different holding period. Mr A sold the asset after 10 years for ₹2 crore, while Mr B sold the asset after five years for ₹2 crore. Both end up paying the same amount of capital gain tax: ₹12.5 lakh (assuming no standard deduction for simplicity). 

Here, the internal rate of return (IRR) made by Mr A is 7%, and Mr B is 15%. Considering the inflation rate of 6% per annum, Mr A hardly made any real returns, while Mr B made a real return of 9%. After a tax of 12.5% without indexation, Mr A earned an IRR of 5.8%, not even beating inflation, and thus incurred a loss in real terms. A fair policy should charge different taxes in such cases.

High inflation

In an economy like India, with long-term high and fluctuating inflation, the impact on purchasing power is more pronounced and harsher. If sold recently, a house purchased decades ago would show considerable LTCG. However, due to high inflation, hardly any real return is made. Tax without indexation benefits would be penalizing. In a low-inflation economy, the absence of indexation benefits for LTCG is not onerous. In India, this doesn't hold and would discourage long-term investments.

Maintenance cost

Maintenance and upgrading costs for property are rising steadily. For older property, such costs have surpassed the original acquisition cost several times every few years in recent times. Unfortunately, people don't keep accounts and proofs and cannot claim such deductions when estimating LTCG. 

Thus, the capital gains would be massive, considering only the original acquisition cost. While provisions for standard deductions are available, are they adequate? Indexation helps moderate the impact.

Time value of money

Time value of money (TVM) is an essential financial concept that holds that money in the present is worth more than the money to be received over a period in the future due to risk, inflation, and deferment of consumptions. 

As per finance wisdom, the gains on a long-term investment must be arrived at after considering TVM. Indexation allows TVM to be factored in for different amounts and periods of investment.

Distress sale

Property is the most significant investment and safety net for common people. In case of selling to meet the emergency, one won’t be able to reinvest proceeds in capital gain bonds or property to avail tax benefit. It would be arduous to levy a capital gain tax without indexation to individuals in perilous situations.

Conclusion

The amendment in the Finance Bill is a win-win for all as it will provide an option to choose between LTCG tax of 20% with indexation or 12.5% without. It would encourage honest tax payment, long-term investment, and fair play. But the exclusion of deals after 23 July 2024 needs to be revisited. The proposed amendment should be for future deals, and allow one to choose the best option. 

Chanakya quotes: "The king must collect tax like a honey bee, enough to sustain but not too much to destroy.” The answer lies in fairness. Yes, the proposed changes are fair and should remain for future deals. The change is complex, and defies simplicity.

Keyur Thaker is professor of finance and accounting at IIM Indore, and serves on corporate boards, and is a mentor to start-ups. Views expressed are personal

Also Read: Reintroduced indexation for property disallows loss offsets, excludes NRIs