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Wednesday, September 26, 2012

Preserve your Property Gains

 
Real Estate, as an investment tool, normally rewards you with enough annual returns, sometimes in line with what stocks can provide you. Though Stocks / Equity still remain the best choice considering relatively smaller investment, liquidity and extremely high return potential, Real Estate (in developing countries) remains the 2nd best option.

Though the upcoming book (From the Rat Race to Financial Freedom) would guide you on how to truly invest in real estate, there are a few tips you should keep in mind when you are selling your real estate investment to book profits or to subsequently invest your profits somewhere else. Knowledge of certain rules and laws would only help you to preserve your gains that you realize through this investment tool.

Short Term Capital Gains
If you sell your property within 3 years (36 months) of the date of acquisition, your property would qualify as a Sort Term Capital Asset (STCA) and the gains that you realize out of this sale would qualify as Short Term Capital Gains (STCG)

Here are the salient taxation laws for Short Term Capital Gains
1. Any STCG is considered as your taxable income for that year and should be included as your income when you file your income tax returns.
2. Since the profits are qualified as income, they are taxed as per the income tax slab applicable for you for that financial year.
3. This is the least efficient means of getting returns from real estate as an investment. One should consider this option only in case of emergency need of funds.


Long Term Capital Gains
If the holding period for your property exceeds 36 months,such property qualifies as a Long Term Capital Asset (LTCA) and the gains realized from its sale as Long Term Capital Gains (LTCG)

Here are the salient taxation laws for Long Term Capital Gains
1. LTCG is taxed at a flat rate of 20% after indexation of cost
2. Indexation of cost is very important and has a significant positive impact on you wrt the tax liability. 
3. Indexation of Cost typically means that for calculation of your gains, the cost of the house is uplifted by the inflation index for each year till the sale is made. So, your net indexed gain is less than the actual gain, resulting in reduced tax liability.

It makes lot of sense to wait for more than 3 years if you are selling your property for investment gains. Let us understand in some more detail through a simplified example.

Example:
Let us assume that you bought a house with the following details
Cost of Purchase : Rs. 20 Lacs
Expenses on improvement : Rs. 5 Lacs
Total Cost : Rs. 25 Lacs
Selling Price : Rs. 40 Lacs

Case 1 : House is sold within 3 years
Applicable Gain : STCG
STCG : Rs. 40 Lacs - Rs. 25 Lacs = Rs. 15Lacs
Taxable Income : Rs. 15 Lacs
If you are in the highest tax bracket (30%), your total tax : Rs. 5 Lacs.

Case 2 : House is old just after 3 years
Applicable Gain : LTCG
Indexation adjusted cost of purchase :  Rs. 33 Lacs (assuming approx 10% inflation every year for 3 years)
LTCG : Rs. 40 Lacs - Rs. 33 Lacs = Rs. 7 Lacs
Taxable Income : Rs. 7 Lacs
Your total tax (flat 20%) : Rs. 1.4 Lacs.

Summary : 
1) You saved Rs. 3.5 Lacs on taxes just by waiting for 3 years to pass by.
2) Education cess is applicable in both cases of LTCG and STCG, though not considered in the above example, just for the sake of simplicity.
3) Note that money spent on house improvement is also included in your cost, and helps you reduce your tax liability.
4) There are laws that help you save or re-invest the LTCG, thus avoiding any tax at all. That topic would in the scope of the next post.

Cheers

Manoj Arora

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