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Investment in realty is illiquid, comes with higher taxes & related costs
There has been a deluge of offers through advertisements aimed at prospective home buyers, for those who will live in that property and also those who want to buy a property as an investment. For the second option—that is buying a real estate now as an investment for future gains—a widely accepted opinion is that investing in property is the best investment, even better than investing in shares. We analyze this belief by looking at the pros and cons of such an investment, and whether the cost and benefit supports it.
An article by Priya Sunder details some personal experience relating to real estate investments, and give a basic idea about the costs and taxes associated with real estate investments that people usually don't take into consideration, mostly because of their inability to add these up. A case study by Urmin Vohra shows that in general, after taking into account all the costs and taxes, returns from real estate can at best be close to returns from bank fixed deposits and recurring deposits but definitely cannot match returns from equity in the long run. Calculations by financial planners also show that in 75% of the property investments, returns from real estate in the long run are usually less than 10% per annum. In comparison, equities have given returns of about 14-15% in the long run.
Compared to equities, one of the major drawbacks of investments in real estate is the illiquidity factor —in most circumstances a property owner can not sell his property very quickly if the need arises. Depending upon market conditions, it could take anything over a month to close a real estate deal. At times, such deals could take over a year to close.
Other than illiquidity, taxes and other costs like high rate of stamp duty and registration also impede investment in real estate. While there is no long-term capital gains tax in equity investment, such a tax liability may arise in case you had invested in a real estate property and want to sell it now. "Unless you buy another property or you invest the money in capital gains bonds, the investor will be charged capital gains tax on the gains from property investments. And even if one invests in capital gains bonds, the net gains come to about 4.5% per annum. Also these bonds come with a three-year lock-in.
The rates of capital gains tax from the sale of a real estate property depend on the duration for which the property was held. Compared to equities, where the long-term capital gains is waived off after just one year of holding, in case of real estate the long term capital gains of 20% after indexation is applicable when the holding period is more than three years. In case of short term capital gains, the rate is according to the income tax slab rate applicable to the investor.
Despite these facts, it cannot be denied that real estate is an important asset class. And there are situations when financial planners advice clients to invest in a property. For one, if the property is being bought for self consumption, then there is no argument to that. Secondly, if you have higher amount of money and is well invested in equity, bonds and gold etc, then you can invest some amount in real estate.
Generally, however, not many financial planners suggest clients to invest in real estate upfront. They first evaluate the merits of investments in all the asset classes, including real estate, and give their nod if investing in a property is found to be suitable to the to an investor's risk profile.
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