WHAT IS INDEXATION:
Indexation is a valuable tool for minimizing the impact of taxes on your investment returns. It applies to long-term investments, such as debt funds and other asset classes, by adjusting the purchase price of the investments. This adjustment helps reduce your tax liability. To fully grasp indexation, it’s important to first understand inflation.
Inflation refers to the gradual increase in the prices of goods and services. For instance, an item priced at Rs.100 today might cost Rs.110 or more next year, and even higher in subsequent years. This rise in prices diminishes your purchasing power over time.
HOW TO CALCULATE INDEXED COST:
The inflation rate for indexation purposes is derived from the government’s Cost Inflation Index (CII). The central government sets these index values, which are regularly updated on the income tax department’s website.
To arrive at Indexed Cost of Acquisition (COA), the following Indexation on capital gain formula should be used:
Indexed Cost of Acquisition=Original COA×(CII for the Year of Sale)/(CII for the year of purchase)
BENEFITS OF INDEXATION:
Indexation is used to adjust the purchase price of an investment to reflect the effect of inflation on it. A higher purchase price means lesser profits, which effectively means a lower tax.
With the help of Indexation, one will be able to lower his/her Long-Term Capital Gains, which brings down his/her taxable income. Indexation is the reason why debt funds are considered an excellent fixed income investment option when compared to conventional FDs. Indexation makes the game of investment a win-win affair.
CHANGES IN INDEXATION BENEFITS INTRODUCED BY BUDGET 2024:
The budget 2024 announced on July 23rd, 2024, brought significant changes to the way capital gains are taxed. One of the biggest changes is the removal of indexation benefits for long term capital gains on property.
This means you can no longer adjust your purchase price of the property for inflation when calculating your tax. However, there is a silver lining; the tax rate on long term capital gains from property has been reduced to 12.5%. While this is lower than before (20%), the removal of indexation might still increase your tax bill, especially if you bought the property a long time ago.
Indexation on Capital Gain Example
Mr. A purchased a house for Rs.1,00,00,000 in 2001. Its value kept increasing due to inflation every year and today the value of the property is Rs. 4,17,00,000.
Let us consider the above-mentioned case in two scenarios and see the difference,
Scenario 1 (With Indexation and Tax at 20%):
(Amount in Rs.)
| Sale value | 4,17,00,000.00 |
| (-) Indexed COA | 3,63,00,000.00 |
| 1,00,00,000 X 363/100 | |
| Long Term Capital Gain | 54,00,000.00 |
| Tax at 20% | 10,80,000.00 |
# CII for the year of sale and purchase is considered from government’s CII
Scenario 2 (Without Indexation and Tax at 12.5%):
(Amount in Rs.)
| Sale value | 4,17,00,000.00 |
| (-) Cost of Acquisition | 3,63,00,000.00 |
| Long Term Capital Gain | 3,17,00,000.00 |
| Tax at 12.5% | 39,62,500.00 |
Mr. A was supposed to pay tax of Rs.10,80,000. But because of removal of indexation benefit he will be liable to pay a huge amount of tax of Rs. 39,62,500. He will be liable to pay additional tax of Rs.28,82,500 even with the lower tax rate of 12.5%.
EFFECTS OF REMOVAL OF INDEXATION BENEFIT:
As a result of removal of Indexation benefit, the real estate investment will drop, and people won’t be able to buy their dream home. It will also lead to undervaluation of property deals to avoid tax and most of the property deals will be done at a circle rate rather than the actual rate. This will also lead to the huge inflow of black money into the real estate sector.
New Finance Bill Amends Long-Term Capital Gains Tax on Immovable Properties: Key Changes Explained:
The Finance Bill was passed in the Lok Sabha on August 7th, 2024, with an amendment relaxing the recently introduced new capital gain tax on real estate. It allows taxpayers an option to switch to a new lower tax rate or stick to the old regime that had higher rate with indexation benefit.
The amendment comes after a proposal to remove indexation benefit in calculation of long-term capital gains on sale of immovable properties in the budget 2024-25 had evoked criticism from various corners, including opposition parties and tax professionals.
With this amendment, individuals or HUF who bought house before July 23,2024, can opt to pay long term capital gain tax under the new scheme at the rate of 12.5% without indexation or claim the indexation benefit and pay 20% tax.
CONCLUSION:
The amendment bill has a very profound impact on both homeowners and aspiring homebuyers as follows:
Homeowners:
This change gives homeowners flexibility in their tax liabilities when they sell their property. For properties held over a long period, where inflation has majorly raised the property’s value, opting for the 20% tax rate with indexation would be beneficial. Indexation adjusts the purchase price for inflation, potentially reducing the taxable gain and overall tax liability. For properties held for shorter periods or in low-inflation periods, the 12.5% rate without indexation could be more beneficial and result in a lower tax burden.
Homebuyers:
This revision has the potential to boost the residential property market by offering clarity and suggesting a possible reduction in tax burdens. Homebuyers’ confidence is likely to improve as they gain more flexible options for managing their future capital gains tax liabilities. This could lead to increased demand, especially in areas where property values have been rising significantly.
It is important to note that this revised proposal only offers taxpayers relief from any additional tax burden that may arise under the new regime. It does not allow taxpayers to choose between calculating capital gains tax under the old or new regime. Therefore, if calculating capital gains under the old regime results in a loss, the taxpayer would not be permitted to recognize this loss in their returns.
