This is an example of how indexation benefits help reduce long term capital gains on property sales. The sold property should be over two years old for applying for indexation benefits.
There are several exemptions like sections 54 (reinvest in a new property), 54ec (buy specific bonds) and 54B (sell agricultural land in non-rural areas to buy agricultural land).
In the present example, we shall assume exemptions do not apply or are not opted for. Why would one not opt for a tax exemption? In the example, we will consider (numbers sent in by a reader who wanted help to pay advance tax).
The tax to be paid was so small compared to the reader’s liquid net worth that it made no sense to seek exemption by purchasing section 54ec bonds. The reader loses or gains much more than this tax amount daily in the capital market. So it makes a lot more sense just to pay the tax and invest the rest into a planned asset allocation.
Taxable capital gains on a property = Sale value of a property minus (expenses like brokerage, lawyer fees, etc.) minus (indexed purchase price) minus (indexed modification costs to property)
What is the indexed purchase price?
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The property in question was purchased in 1995. So, a property valuator was asked to determine the property value as of 1st April 2001 – the year cost inflation index was reset to 100. This value is Rs. 12 Lakhs.
The current cost inflation index is 348. So, the indexed purchase price = 12 x 348/100 = 41.76 lakhs.
A similar indexation benefit is also applicable to any renovation costs on the property. For the moment, we will assume there are no renovation costs or expenses associated with the purchase. These would only reduce the tax to be paid.
The property was sold for Rs. 70 lakhs. So, the indexed capital gain is 70 minus 41.76 = Rs. 28.24 lakhs.
The income tax on this amount at the rate of 20% is Rs. 5,64,800
Add 4% Health and Education Cess = Rs. 22,592 (4% of 5,64,800)
So, the total tax to be paid is Rs. 5,87,392.
Now imagine if indexation benefits were not available!
Taxable capital gain is Rs. 70 lakhs minus Rs. 12 Lakhs = Rs. 58 Lakhs. The total tax plus cess would then be Rs. 12,06,400!
So, thanks to the indexation of the purchase price, the tax liability has decreased by 6.19 lakhs. This corresponds to a percentage decrease (5.874 – 12.064 )/12.064 of 51%. If we factor in expenses related to the sale and indexed cost of renovations, the tax would be even lower.
This article aimed to show the importance of indexation in lowering capital gains tax. It is a pity that debt mutual funds are no longer subject to this wonderful benefit. We also believe indexation should be allowed while computing equity tax gains.