On discarding indexation for long-term capital gains | Explained

Finance Minister Nirmala Sitharaman's budget proposal to eliminate indexation for LTCG tax receives mixed reactions from experts and taxpayers.

The story so far: Finance Minister Nirmala Sitharaman’s announcement in the Union Budget about doing away with indexation for computing long-term capital gains (LTCG) tax has not drawn much enthusiasm. She had proposed that long-term gains on all financial and non-financial assets would now be taxed at 12.5% instead of a tiered structure, albeit abandoning indexation. A memorandum explaining the provisions of the Finance Bill (2024), stated that this was to “ease computation of capital gains for the taxpayer and tax administration”.

Imagine, an individual buys a house for ₹10 lakh in 2001. For reasons such as inflation and/or a vibrant property market, they are able to sell the same property in 2021 at ₹75 lakh. Here, it may appear that they gained ₹65 lakh and should be taxed accordingly.

However, the figure does not consider the price levels prevailing at the time of sale with that of purchase. This is where the Cost Inflation Index (CII) comes in. Indexation ensures that taxpayers are taxed on real gains than gains at prevailing prices, which are a result of general increase in prices, and not economic growth, during the course.

In the stated example, the CII for 2021 (that is, 317) would be divided by that for the base year 2001 (100) to derive a number. It would then be multiplied with the purchase price (that is, ₹10 lakh). Thus, the indexed cost becomes ₹31.7 lakhs and the individual’s taxable gain is revised downwards to ₹43.3 lakhs. At the erstwhile 20% rate, they would now be required to pay a long-term capital gains tax of approximately ₹8.7 lakhs. With the new system however, the ₹65 lakh would be taxed at a lower 12.5%. Thus, a tax liability of ₹8.13 lakh.

Abhijit Mukhopadhyay, consulting economist at the Secretariat explained to The Hindu that the eventual tax liability is broadly determined by two factors, that is, the rate on return and the subjected time-period.

In this light, it is essential to note that not all assets may experience the same exponential growth as in the example above. This could be because of a flat market or a temporary period of slump. This is primarily where the indexation turns out to be more favourable. To illustrate, let us say that in 2021 instead of ₹75 lakh, the house is sold for ₹40 lakh. When adjusted with indexation, the tax liability is ₹1.66 lakh against ₹3.75 lakh without indexation.

Furthermore, a BankBazaar study, basing an assessment from the RBI’s House Price Index, observed that without indexation, LTCG tax went up about three times on properties purchased after 2010. Keeping its base year as FY 2010-11, the study noted a “severe loss of tax savings” especially in the years from 2016-17. “From zero tax liability across the board, we see significant liabilities arising for these years (since 2016-17),” the study found. The Income Tax department, however, estimates that real estate returns (12-16% per annum) are much higher than indexation for inflation (4-5%), depending on the period of holding. Therefore, it predicts “substantial tax savings” to a “vast majority” of taxpayers.