The Flawed Tax Reform: How Removing Indexation on Real Estate Will Hurt the Market
The government's decision to remove indexation on real estate transactions will lead to adverse implications for the market and economy, contrary to claims of benefiting the middle class.
Real EstateLong Term Capital GainsLtcg TaxIndexationFinance MinistryBudgetReal EstateJul 31, 2024
Let us first dissect the core components of the policy change. The reduction in the LTCG tax rate to 12.5% appears beneficial at first glance. However, this apparent benefit is offset by the removal of the indexation benefit, which previously allowed taxpayers to adjust the purchase price for inflation. Without this adjustment, the taxable gains are calculated on the nominal increase in property value, disregarding the erosive effect of inflation.
In a market with a relatively inelastic supply such as real estate, an increased tax burden is likely to weigh heavily on buyers through higher prices, with a potentially smaller impact on transaction volumes. This effect may be especially pronounced in the short to medium term.
To quantify the impact, we analysed the compound annual growth rate (CAGR) of real estate prices, the holding period, and the cost inflation index. Our calculations show that the effective tax rate under the new regime is only lower if the real estate's CAGR significantly exceeds historical averages. For a 20-year holding period with a cost inflation rate of 5.5% a year, the CAGR must be above 9.48% for the new tax structure to be advantageous.
An examination of actual performance of the real estate market provides more insights. Data from the National Housing Bank's Residex, covering March 2013 to March 2024, shows the average CAGR of property prices across 36 Indian cities is just 5.11%. The highest recorded CAGR is 8.56% in Hyderabad, which is still below the threshold needed to benefit from the new tax regime. This suggests that, contrary to the finance ministry's claims, the effective tax burden will increase for most real estate investments.
The demographic aspect of real estate transactions is another crucial consideration. Most real estate sales are conducted by individuals with annual incomes exceeding ₹15 lakh, meaning that the new tax policy will disproportionately affect higher-income groups. While the government aims to redirect the increased tax revenue to support lower-income groups, doing so by presenting misleading claims that nominal real estate returns are in the 12-16% range is problematic.
Also, the lack of indexation means that inflation-adjusted gains will be taxed more heavily, potentially discouraging long-term investment in real estate. This could lead to reduced market liquidity, a crucial factor for efficient price discovery and resource allocation. Reduced liquidity can lead to higher transaction costs and price volatility, potentially destabilising the real estate market. This could also have spillover effects on the banking sector, given the significant proportion of loans backed by real-estate collateral.
The removal of indexation could have other regressive effects, too. Unlike financial assets, real estate often appreciates in nominal terms, without corresponding increases in real value. By taxing nominal gains, the policy disproportionately affects those who have held properties for longer periods, including retirees and long-term investors for whom real estate is a significant part of retirement planning. This could force some individuals to sell their properties prematurely to avoid higher taxes, leading to potential disruptions in the real estate market.
Finally, the policy's impact on real estate developers should not be overlooked. Already facing challenges such as regulatory hurdles, fluctuating demand and high financing costs, developers may find that the new tax regime adds another layer of strain. Increased taxes on gains from property sales could reduce profit margins, leading to longer completion times and higher costs for homebuyers. Given that affordability is already a critical issue, this could exacerbate the housing crisis and make it harder for the average Indian to own a home.
From a policy perspective, reintroducing the indexation benefit would align the tax burden more closely with real gains, providing a fairer and more transparent tax structure. A phased approach to reducing the tax rate and indexation could balance the need for revenue with the principles of equity and efficiency. Additionally, clear and accurate communication from the government, based on empirical data rather than optimistic projections, would foster greater trust and compliance among taxpayers.
The government should establish a real estate data repository to address the disconnect between policy assumptions and market realities. This would enable more accurate forecasting, facilitate evidence-based policymaking, and improve market transparency. Such a repository could provide crucial insights into regional variations in real estate performance, allowing for more targeted and effective policy interventions.
Frequently Asked Questions
What is the current LTCG tax rate on real estate?
The current LTCG tax rate on real estate is 12.5%.
What is the impact of removing indexation on real estate transactions?
Removing indexation will lead to an increased tax burden on real estate transactions, potentially discouraging long-term investment and reducing market liquidity.
Who will be most affected by the new tax policy?
Higher-income groups, including retirees and long-term investors, will be disproportionately affected by the new tax policy.
What is the average CAGR of property prices across 36 Indian cities?
The average CAGR of property prices across 36 Indian cities is 5.11%.
How can the government improve the tax policy on real estate?
The government can improve the tax policy by reintroducing the indexation benefit, implementing a phased approach to reducing the tax rate and indexation, and establishing a real estate data repository.
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