Date:11/05/2008 URL: http://www.thehindubusinessline.

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Back When paying tax creates more money!

Understanding long-term capital gains from buildings and the options available to the
taxpayer.

J. Karthikeyan
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Capital Gains is one of the headings under which
direct tax is levied. It is calculated differently for
different entities — shares, land, building, different types of mutual funds, etc. Also capital gains
can be long term or short term. Short term capital gains are taxed higher than long-term gains.
Calculation of long term capital gains for financial instruments is easy. It is Nil (zero) for shares
and equity oriented mutual funds. Long term here is considered to be one year (365 days). Don’t
you feel like giving our friendly taxman a tight hug?

LTCG on Buildings

In this article, we focus on long-term capital gains from buildings. Long term for capital gains of
buildings is three years (36 months). The calculation is simple again. Let’s understand how this is
done.

Calculating LTCG on Buildings, with Indexation Benefit

Sales Proceeds:

Less: Expenses on Transfer (stamp duty, registration charges, legal fees, brokerage and so on)

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 Less: Indexed Cost of Acquisition

Less: Indexed Cost of Improvement

Equals LTCG LTCG Tax will be 20 per cent of LTCG Simple!! Well not so simple, because I
have not explained indexation.

Why and What is Indexation?

LTCG Tax is paid logically for the contribution the Government has made towards the
improvement of value of our property. This may be directly or indirectly through roads,
electrification, security, industries, educational institutions, etc, which have been
established/allowed to be established by the Government. It is true that we need to contribute a
portion of our earnings for these services received.

But as tax payer we have the right to ask, “But the prices of many things around me have
increased — rice, wheat, bricks, steel, cement, petrol, my toothpaste, my child’s school fees, etc
— so doesn’t my property value appreciation also merit consideration?”

The IT Department takes this too into consideration. It declares an Indexation Number based on
inflation and other factors, which can be used for discounting the appreciation of property value.

Indexation Calculations

Let’s do a calculation to understand how indexation works. Let us assume that one Mrs
Hemalatha bought a house for Rs 4,00,000, including all expenses, on April 1, 1995. She made
some modifications to the house for Rs 1,00,000 on April 1, 2000.

Supposing she sold the house on April 1, 2007, for Rs 15,00,000 (after deducting all charges), the
long-term capital gains will be calculated as follows:

With Indexation: (Table 1)

Without Indexation (Table 2)

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 Tax for Mrs Hemalatha, using Indexation tax rate, is 20 per cent of LTCG, which equals Rs
1,15,989. The IT department also gives you another choice, to not pay even this tax. This is to
invest in Capital Gains Bonds (issued by specified Government Bodies).

Way to Reduce LTCG TAX to ZERO

Option 1

Investing LTCG in Capital Gains Bonds issued by Rural Electrification Corporation and National
Highways Authority of India will reduce the tax to zero.

The bonds give Mrs Hemalatha a return of 5.50 per cent (simple interest) with a minimum lock-in
period of three years (36 months). This interest is taxable, though.

The scenario when Mrs Hemalatha makes the investment in Capital Gains Bonds will look like
this (Table 3)

Option 2

Mrs Hemalatha can invest the Capital Gain in another house within two years of the sale of the
old property. However, during this period, the capital gain has to be deposited in a separate bank
account meant for this purpose.

Also, the new house bought cannot be sold for the next three years. There we go again. The
question to ask here is, “Does Mrs. Hemalatha want to perpetually lock her money in one
property after another?”

Option 3 – What Happens When I Pay The Tax?

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 Mrs Hemalatha has the other option too — one that may appear to be crazy for many, because
we always tend to reduce our taxes. The option is to pay the tax in full. And invest the rest in
other financial tools.

When we look at financial planning as a whole, tax is just one part of it. When we look at the
whole picture, we need to look at different options and the objective becomes one of maximising
the returns over a period of time. Even if this means one pays higher taxes!

Let’s take a detailed look at this scenario:

The average return of Index Funds over the last three years has been 49.60 per cent
(compounded annually). The average return of Index Funds over the last five years has been
44.72 per cent (compounded annually).

The average returns from the Sensex since inception in 1979 has been about 20.10 per cent.

(The Bombay Stock Exchange, which had its origin under a banyan tree, is much older. Only its
index started in 1979.)

Let us use that as the reference and calculate how much Mrs Hemalatha will have after three
years (Table 4)

Also, the receipts from the mutual funds after three years are LTCG-Tax-free. Is that not
wonderful?

I pay my taxes and serve the nation and also make money because I paid my taxes. Now that’s
what I call a win-win situation.

(The author is one of the founders, and Director–Operations, Finerva Financial Solutions Pvt
Ltd.)

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