Updated on: Apr 25th, 2023
8 min read
As the end of the financial year approaches, it is probable that you are thinking of tax saving options on the investments you have made over a period of time. The most common investments being, equity shares, mutual funds, etc. which provide a higher rate of return compared to the traditional fixed deposits investments. With the amendments on taxability of shares/stocks, mutual funds, etc. brought about in Budget 2018, which seek to impose taxes on Long-Term Capital Gains (LTCG) in excess of Rs 1 lakh at the rate of 10%, on sale or redemption as the case may be, after 31 March 2018, a little amount strategic planning will still help you save your taxes.
Capital gains are the profits made by investors when they sell their assets for a higher price than they paid for them. Property such as land, vehicles, and jewellery, as well as shares and stocks, are examples of capital.
Capital gains are taxable, and there are two types: short-term and long-term. Short-term capital gains result from the sale of an investor's property held for up to 36 months (3 years) or equity shares and bonds held for up to 12 months (1 year), whereas long-term capital gains result from the sale of property held for more than 36 months and equity stocks and bonds held for more than 12 months.
Although there are no tax exemptions for short-term capital gains, long-term capital gains are tax deductible. This means that if you follow specific standards outlined in the Income Tax Act, you can legitimately save on long-term capital gains tax. One of the key requirements for avoiding capital gains tax is to reinvest the proceeds from the sale of the property in a residential property.
Let us look at the three primary long-term capital gains tax exemptions:
1. Section 54: This section addresses long-term capital gains on the sale of a home and the reinvestment of the proceeds in another home.
2. Section 54EC: This section addresses long-term capital gains on the sale of a home and the reinvestment of the proceeds in designated bonds.
3. Section 54F: This relates to long-term capital gains on the sale of any asset other than a house and the reinvestment of the proceeds in the purchase of a dwelling.
4. Capital Gains Account Scheme (CAGS): If you are unable to invest long-term capital gains within the time frame stipulated, you can deposit the funds in a CAGS account. The funds must be used to construct or purchase another residential property within a specified time frame.
Assume you're selling a home you've owned for more than three years. The house cost Rs. 20 lakh when you acquired it, and you are selling it for Rs. 42 lakh. In this situation, you earn a profit of Rs. 22 lakh and must pay long-term capital gains tax on this amount. According to the guidelines, you must pay 20% LTCG tax, as well as a 3% surcharge and cess. However, if you use the proceeds from the sale of the previous home to purchase another residential property, you will be excluded from paying this tax.
Section 54 exempts you from paying LTCG tax if you acquire a new house either one year before or within two years of selling your old one. If you intend to build a new house, you must do so within three years of selling your old one. You can claim an exemption on all capital gains or up to the cost of a new residential property, whichever is less. In the preceding example, if you purchase a new house for Rs.22 lakh or higher, you will not be required to pay any LTCG tax.
1. You can only claim an exemption for the acquisition of one house. If you use capital gains to acquire more than one house, you can only claim an exemption for the cost of one dwelling.
2. You are only eligible for an exemption under Section 54 if you are purchasing a home in India. Any residential property purchased outside of the country will not be excluded from LTCG tax.
3. You cannot sell the new house purchased using the proceeds from the sale of the previous house for three years after the purchase or completion of construction. This means that if you sell the new house before 3 years of its purchase/construction is completed, the benefit received by you under Section 54 will be revoked and you will have to pay the LTCG tax.
Other long-term assets, such as land, commercial buildings, stocks, equities, bonds, automobiles, patents and trademarks, jewels, and machinery, provide capital gains as well. For example, you want to sell equities you've held for more than a year (in the case of equity funds) or three years (in the case of debt funds). You purchased the stocks for Rs. 15 lakh and sold them for Rs. 23 lakh. You are getting a capital gain of Rs. 8 lakh in this scenario. This cash may be tax-free if invested in the purchase or construction of a new residential property.
Section 54F exempts you from paying LTCG tax on the sale of property other than a house if you utilise the capital gains to buy a new house. The new residence should be purchased either one year before or within two years of the sale of the long-term asset. If you intend to build a new house, it must be completed within three years of the sale of the existing one.
If you invest the whole capital gains amount in buying the new house, you can get total exemption. However, if you are using only a portion of the capital gains amount, you get tax deduction on the proportion of the invested amount to the sale value.
Section 54F has the same exceptions as Section 54: you can only buy one house, you must buy it in India, and you cannot sell it for the next three years.
There is another approach to reduce LTCG tax if you are selling a long-term asset but do not intend to invest in a new dwelling. Capital gains must be invested in notified bonds. The interest rate on these bonds is 6%, and they are typically issued by government agencies such as the Rural Electrification Corporation (REC) and the National Highways Authority of India (NHAI). The interest earned is not tax-free.
Section 54EC provides that you do not have to pay LTCG tax on the sale of any long-term capital if the capital gains are invested in particular designated government bonds and instruments. The bonds must be purchased within six months following the asset's sale. The most you can invest in this manner is Rs.50 lakh. This investment, however, is limited to a single fiscal year. If the 6-month period is divided into two fiscal years, you can invest Rs.50 lakh twice and receive tax deductions of up to Rs.1 crore.
1. You are only entitled for a tax break if you invest in the notified bonds and securities. For further information, contact your tax preparer.
2. You will lose this exemption if you sell these bonds within three years after obtaining them.
3. This exemption will be removed if you borrow against these bonds within three years after acquisition.
Section 54 and Section 54F are complemented by the Capital Gain Deposit Account (CGDA) Scheme, 1988. If you are unable to use all of the capital gains from a transaction by the due date for submitting your income tax return, you can deposit the unutilized amount in any public sector bank under the CGDA Scheme. Once the money is in this account, you must utilise it within two years (if you are buying a new house) or three years (if you are building a new house).
You must open the account before the deadline for filing your IT return, and the funds must only be used to purchase a residential property. If the money is not used to purchase a home within the time restriction, the capital gains will be taxed.