Section 54 of Income Tax Act - Capital Gains Exemption

“Invest in property now, keep it for a few years and then sell it off for a higher price”. This has been the mantra for individuals who look for secured, less risk and less volatile investments.

However, while designing their strategies, many a time the most important component – tax planning is often forgotten. You can plan a sale of immovable property and reinvestment with planning for tax exemptions.

Latest Update

Budget 2023: Long-term capital gain exemption will be capped at ₹10 crores on sale of: 

Introduction

Firstly, let us understand which portion of the income is taxable on sale of the property. Is it the entire amount received on sale of property?
The answer is NO. 

In simple words, it is only the profit earned by the individual on sale of the property that is taxable. Profit is the difference between the sale price and the cost of the asset. 

A sale of a residential house is a sale of a capital asset, and the profit gets taxed as a capital gain. 

The definition of capital asset under section 2(14) of the Income Tax Act includes property of any kind movable or immovable, tangible or intangible held by the assessee for any purpose. 

As per the income tax act, for the purpose of capital gains, assets are classified into 2 types depending on the holding period of the asset:

• Short-term capital asset
• Long-term capital asset

What are the benefits of an asset being classified as a long-term capital asset?

The major benefit of an asset being termed as a long-term capital asset is that the assessee is eligible for the benefit of indexation. Moreover, certain exemptions are eligible only for long-term capital assets.

Exemption under Section 54

Under Section 54 the Income Tax Act, an individual or HUF selling a residential property can avail tax exemptions from Capital Gains if the capital gains are invested in purchase or construction of residential property. 

Taxpayers such as partnership firms, LLP’s, companies or any other association or body cannot claim tax exemption under section 54. The conditions that need to be satisfied to avail the benefit of the said section are as follows:

• Asset must be classified as a long-term capital asset.
• The asset sold is a Residential House. Income from such a house should be chargeable as Income from House Property
• The seller should purchase a residential house either 1 year before the date of sale/transfer or 2 years after the date of sale/transfer. In case the seller is constructing a house, the seller has an extended time, ie. the seller will have to construct the residential house within 3 years from the date of sale/transfer. In case of compulsory acquisition, the period of acquisition or construction will be determined from the date of receipt of compensation (whether original or additional compensation)
• The new residential house should be in India. The seller cannot buy or purchase a residential house abroad and claim the exemption.
• From 1st April 2023 the capital gains tax exemption under Section 54 to 54F will be restricted to Rs.10 crore. Earlier, there was no threshold.

The above conditions are cumulative. Hence, even if one condition is not fulfilled, then the seller cannot avail the benefit of the exemption under Section 54. 

With effect from Assessment Year 2020-21 corresponding to FY 2019-20, a capital gain exemption is available for purchase of two residential houses in India. However, the exemption is subject to the capital gain not exceeding Rs 2 crore. Also, the exemption is available only once in the lifetime of the seller.

What is the amount of Exemption available under Section 54 of the Income-tax act?

The amount of exemption under Section 54 of the Income Tax Act for the long-term capital gains will be the lower of:

• Long Term Capital gains arising on transfer of residential house, Or
• The investment made in purchase or construction of a new residential house property. Hence, the balance capital gains (If any) will be taxable.

To illustrate:

• Mr X sells his villa(house property) for Rs 45,00,000/-
• With the proceeds of the sale, he purchases another villa for Rs 20,00,000/-
• Capital Gains will be computed as follows

The exemption will be lower of the Capital Gains (Rs 45,00,000) or investment in new property (Rs 20,00,000), so the exemption will be Rs 20,00,000.

What are the provisions relating to the transfer of property after claiming benefit under Section 54?

If the new house is sold within 3 years from the date of purchase or construction,  then the exemption claimed earlier under section 54 shall be indirectly taxable in the year of sale of the new house property. Let’s consider two scenarios when the new house is sold within 3 years from the date of purchase or construction:

Case 1: Cost of the new house purchased is less than the capital gains computed on the sale of the original house.

Generally, when a house is sold, the profit is considered as capital gains. However, when the new house is sold within 3 years from the date of purchase or construction, then the cost of acquisition will be considered as Nil. Hence, there will be an indirect increase in taxable capital gains

Example

Mr Y has sold residential house property in May 2015 and the capital gains amounted to Rs. 30,00,000/- In June 2015, Mr Y purchased a residential house property worth Rs. 18,00,000/- 

Mr Y sells the new residential house property (Purchased in June 2015) in December 2016 for Rs. 35,00,000/- 

Based on the facts mentioned above, lets compute the taxable capital gains for Mr Y . FY 15-16 (Property sold in May 2015)

FY 16-17 (Property sold in December 2016)

Note: 
As the new property for which deduction was claimed under Section 54 was sold in December 2016 (ie within 3 years from the date of acquisition), hence it’s cost of acquisition was considered as NIL. 

As a result, the entire sale consideration was considered as capital gains. Had the property been sold after 3 years , ie after June 2018, then in such case the cost of acquisition would be available as a deduction and capital gains would reduce.  

Case 2: Cost of the new house purchased is more than the capital gains computed on the sale of the original house 

If the cost of the new asset purchased is greater than the capital gains, then it is obvious that there will be no capital gains as the entire capital gains will be exempted. However, if the new house is sold within 3 years, then cost of the new house will be computed as follows:  

Example

Let’s understand the above case with the help of an example Mr Z has sold a residential house property and the capital gains is Rs 25,00,000/- in June 2015. 

In October 2015, Mr Z purchased a new residential house property of Rs 40,00,000/- In January 2017, Mr Z sold the new residential house Property for Rs 55,00,000/- 

Based on the capital gains mentioned above, let’s compute the taxable capital gains for Mr Z FY 15-16 (Property sold in June 2015)

FY 16-17 (Property sold in January 2017)

Working Note 1: Computation of cost of acquisition (As the property was sold within 3 years of purchase and Section 54 was claimed)

What is Capital Gains Account scheme?

If the asset is sold in the PY, and the seller intends to, but is yet to purchase the new house property as the time limit of 2 years or 3 years has not yet expired, then the assessee is required to deposit the amount of gains in the Capital gains account scheme (in any branch of public sector, bank) before the due date for filing income tax returns. 

The amount already incurred towards purchase/construction along with the amount deposited in the capital gains account scheme can be claimed as cost while claiming the deduction.

However, if the amount deposited in the Capital Gains Account Scheme is not utilized within the time limit mentioned, then it shall be treated as income of the previous year in which 3 years expire (from the date of transfer of the original asset).

Section 54 vs Section 54F

Earning income automatically casts a responsibility on the taxpayers to discharge income tax on such income and so is the case with capital gains too. However, the income tax laws allow taxpayers to claim certain exemptions against capital gains, which will help reduce their tax outgo.

Two such very crucial exemptions one can claim are under Sections 54 and 54F. As discussed above the exemption under Section 54 is available on long-term Capital Gain on sale of a House Property. Exemption under Section 54F is available on long-term Capital Gain on sale of any asset other than a House Property.

Common requirements between the two Sections

• A new residential house property must be purchased or constructed to claim the exemption
• The new residential property must be purchased either 1 year before the sale or 2 years after the sale of the property/asset.
• Alternately, the new residential house property must be constructed within 3 years of the sale of the property/asset
• If you are not able to invest the specified amount in the manner stated above before the date of tax filing or 1 year from the date of sale, whichever is earlier, deposit the specified amount in a public sector bank (or other banks as per the Capital Gains Account Scheme, 1988).
• Only one house property can be purchased or constructed. The exemption for 2 properties for capital gains up to Rs 2 crore is only once in a lifetime benefit under Section 54.

Key points to remember

• If the cost of the new residential property is lower than the total sale amount, then the exemption is allowed proportionately. For the remaining amount, you can reinvest the money under Section 54EC within 6 months. 
• The property must only be bought on the name of the seller and not on anybody else’s name.
• If the builder of the new residential construction fails to hand over the property to the taxpayer within 3 years of purchase, the exemption is still allowed.

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