Realty beckons: Will your taxes skyrocket by 1,000%?

With the new rules effective from 23 July, the shift from a 20% LTCG tax rate with indexation benefits to a reduced rate of 12.5% without indexation could dramatically increase your tax burden from property sales, especially for those who have seen modest appreciation in their investments.

As the real estate markets grapple with this change, investors and property owners must navigate a landscape where tax implications might outweigh the benefits of modest market gains.

Evaluating real estate returns

According to the Income Tax Department, nominal real estate returns typically range between 12% and 16% annually. In contrast, the government’s cost inflation index (CII) indicates an inflation rate of only 4-5%.

The recent change in real estate taxation—from LTCG tax rate of 20% with indexation to 12.5% without indexation—promises “substantial tax savings” for most taxpayers, according to the I-T department.

However, data from Knight Frank and RBI Housing Price Index, indicates otherwise, especially with compound annual growth rates (CAGR) in real estate over the last two, five, and 10 years ranging between 1% and 7%. Besides, the RBI Housing Price Index data suggests that while some regions may experience high returns, the overall market trends are more subdued.

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In this backdrop, while the new structure could result in tax savings for those with high short-term gains, it may increase tax liabilities for long-term investors who previously benefited from indexation adjustments.

“Real estate as an asset class is known for its stability, moderate returns and diversification rather than high growth potential like equities,” said Vivek Rathi, national director, research, Knight Frank India.

“It tends to earn 1-2% more than inflation in the long run. So, if inflation is 6% and the average return is 8%, you are at a disadvantage on an empirical basis in the new structure because the indexation shield that protected you from inflation has been taken away. The new tax structure, however, benefit those who have incurred huge returns over the last couple of years since we have been in a property upcycle,” he added.

Old vs new structure

Under the old tax structure, LTCG on real estate were taxed at 20% with indexation. Indexation adjusted the purchase price for inflation, reducing the taxable amount.

The new tax structure imposes a 12.5% LTCG tax on real estate without allowing indexation benefits. This means that the gains from selling a property will be taxed at a flat rate of 12.5%, and will not be adjusted for inflation. Consequently, the taxable gain will be calculated based on the original purchase price, potentially leading to a higher tax liability compared to the previous system where indexation was applied.

However, properties held before 2001 will be valued at fair market value as on 1 April, 2001.

Know the difference

Assume you purchase a property for 100, which has appreciated at a compounded annual growth rate of 5% over the past two years (FY23 to FY25) to 110. Adjusting for inflation using the Cost Inflation Index (CII), the current purchase price is 109.6 (calculated as 100 * 363/331).

Under the old structure, the tax amount would be 0.10, compared to 1.30 under the new tax structure, representing an increase of over 1,000% in tax liability. 

If the holding period extends to 20 years, the inflation-adjusted purchase price would exceed the market value, reaching 321, resulting in a long-term capital loss of 55.90. While the old regime allowed this loss to be offset against capital gains from other asset classes for up to eight years, the new regime taxes all scenarios without providing such offsets. 
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“The new structure will impact relatively shorter-term investments (less than five years) where market price growth is below 10% p.a. Conversely, the impact of this new regime would be neutral or marginally beneficial for investments with longer holding period (above 10 years) and where property price appreciation is more than 10% p.a,” according to a report by CLSA, a capital markets and investment group focused on alternative investments.

Tax saving strategies

Note that you can save taxes under section 54EC by investing up to 50 lakh of capital gains in specified bonds, and up to 10 crore under section 54 by buying or constructing a house. The new tax structure will not affect end-users who reinvest in new properties but will impact real estate investors seeking to profit and invest elsewhere.

The abolition of indexation and amendments to reporting rental income will also limit the expenses investors can claim, increasing taxable income and reducing overall returns.

“This is not only because of the abolition of indexation rules, but also because of the other amendment on reporting rental income under the heading ‘Income from House Property’,” said Sunil Dewali, co-chief executive, Andromeda Sales & Distribution Pvt. Ltd.

“This change will limit the expenses investors can claim, and increase their taxable income and tax liability, thereby reducing the overall return from investment. Looking at both amendments together, future returns from real estate investments may be impacted, potentially deterring investors who purchase properties solely for returns —both rental and capital appreciation.”

Pricing and market implications

Despite the tax changes, real estate prices are expected to remain stable, driven by demand and supply rather than tax considerations. “The taxation could be in discussion for a few weeks or so, but it’ll be business as usual soon. The property pricing will primarily be governed by demand and supply dynamics and its inherent value proposition, and in a very limited way on how much tax one has to pay on it,” said Rathi of Knight Frank.

The new structure may also impact money laundering and underreporting. Lower tax rates could make it easier to convert unaccounted money into accounted money through real estate transactions.

“Such people can show the purchase price at the stamp duty value and pay the remaining price in cash to the seller. At the time of sale (say after two years), they will show the entire sale consideration as the sale value. Thus, the capital gain amount will be higher, which will help them to make that gain amount accounted. They will have to pay only 12.5% on the gain amount and convert it to accounted money.”

In fact, the old regime’s 20% tax served as a deterrent to such practices. “The 20% tax on long-term capital gain (with indexation) would have been a deterrent to some extent due to the higher rate for such conversion but would have helped a long-term genuine investor,” Rathi added.

Conclusion

Real estate continues to be a stable investment, but expectations for high returns should be moderated by current market conditions and the new tax regime. It still makes sense for end users but investors aiming for attractive post-inflation returns may prefer equities.