Taxation on capital gains

Section I: The basics

What is a capital gain?

Any profit or gain that arises from the sale of a 'capital asset' is a capital gain. This gain or profit is charged to tax in the year in which the transfer of the capital asset takes place.

No capital gains is applicable when an asset is inherited because there is no 'sale', only a transfer. However, if this asset is sold by the person who inherits it, capital gains tax will be applicable. The Income Tax Act has specifically exempted assets received as gifts by way of an inheritance or will.

What is a capital asset?

Here are some examples of capital assets: land, building, house property, vehicles, patents, trademarks, leasehold rights, machinery, jewellery.

This includes rights in or in relation to an Indian company, including rights of management or control or any other right.

The following are not considered capital assets:

• Any stocks or consumables or raw material held for the purpose of Business or Profession
• Personal goods such as clothes, furniture held for personal use.
• Agricultural land in India in a rural area¹
• 6½% Gold Bonds, 1977 or 7% Gold Bonds, 1980 or National Defence Gold Bonds, 1980 issued by the Central Government
• Special Bearer Bonds 1991
• Gold Deposit Bond issued under the Gold Deposit Scheme, 1999

¹Definition of Rural Area - from AY 2014-15 - Any area which is outside the jurisdiction of a municipality or cantonment board having a population of 10,000 or more is considered Rural Area, if it does not fall within distance(to be measured aerially) given below - (population is as per the last census).

What are long-term and short-term capital assets?

A capital asset held for not more than 36 months or less is a short-term capital asset. An asset that is held for more than 36 months is a long-term capital asset.

For example, a house property held for more than 3 years is termed as a long-term capital asset, whereas equity funds are considered short-term when held for 12 months or less. Debt Funds are long-term assets when held for more than 36 months.

Some assets are considered short-term capital assets when these are held for 12 months or less. This rule is applicable if the date of transfer is after 10th July 2014, irrespective of what the date of purchase is.

The assets are:

• Equity or preference shares in a company listed on a recognized stock exchange in India
• Securities (like debentures, bonds, Govt securities etc) listed on a recognized stock exchange in India
• Units of UTI, whether quoted or not
• Units of equity oriented mutual fund, whether quoted or not
• Zero coupon bonds, whether quoted or not.

When the above listed assets are held for a period of more than 12 months, they are considered long-term capital asset.

In case an asset is acquired by gift, will, succession or inheritance, the period this asset was held by the previous owner is also included when determining whether it's a short term or a long term capital asset. In case of Bonus Shares or Rights Shares the period of holding is counted from the date of allotment of bonus shares or Rights Shares respectively.

Tax on short-term and long-term capital gains

Tax on long-term capital gain: Long-term capital gain is taxable at 20% + surcharge and education cess.

Tax on short-term capital gain when securities transaction tax is not applicable: If securities transaction tax is not applicable, short-term capital gain is added to your income tax return and the taxpayer is taxed according to his income tax slab.

Tax on short-term capital gain if securities transaction tax is applicable: If securities transaction tax is applicable, short-term capital gain is taxable at the rate of 15% +surcharge and education cess.

Tax on equity and debt mutual funds

Gains made on sale of debt funds and equity funds are treated differently. Funds that invest heavily in equities, usually exceeding 65% of their total portfolio, is called an equity fund.

Change in tax rules for debt mutual funds

Debt mutual funds have to be held for more than 36 months to qualify as a long-term capital asset. This change, in effect from last year's Budget, means that investors would have to remain invested in these funds for at least three years to take the benefit of long-term capital gains tax.

If redeemed within three years, the capital gains will be added to one's income and will be taxed as per one's income tax slab.

Section II: Calculating capital gains

Capital gains are calculated differently for assets held for a longer period and for those held over a shorter period.

Terms you need to know

Full value consideration

The consideration received or to be received by the seller in exchange of his assets, which he has transferred. Capital gains is chargeable to tax in the year of transfer, even if no consideration has been received.

Cost of acquistion

The value for which the capital asset was acquired by the seller.

Cost of improvement

Expenses incurred to make improvements to the capital asset by the seller. Note that improvements made before April 1, 1981 is never taken into consideration.

How to calculate short-term capital gains?

1. Start with the full value of consideration
2. Deduct the following:
• expenditure incurred wholly and exclusively in connection with such transfer
• cost of acquisition
• cost of improvement
3. From this resulting number, deduct exemptions provided under sections 54, 54EC, 54F, 54B
4. This amount is short-term capital gain.

How to calculate long-term capital gains?

1. Start with the full value of consideration
2. Deduct the following:
• expenditure incurred wholly and exclusively in connection with such transfer
• indexed cost of acquisition
• indexed cost of improvement
3. From this resulting number, deduct exemptions provided under sections 54, 54EC, 54F, 54B
4. This amount is long-term capital gain.

Expenses that can be deducted from full value for consideration

Expenses from sale proceeds from a capital asset, that wholly and directly relate to the sale or transfer of the capital asset are allowed to be deducted. These are the expenses which are necessary for the transfer to take place.

In case of sale of house property, these expenses are deductible from the total sale price:

• Brokerage or commission paid for securing a purchaser
• Cost of stamp papers
• Travelling expenses in connection with transfer - these may be incurred after the transfer has been affected
• Where property has been inherited, expenditure incurred with respect to procedures associated with the will and inheritance, obtaining succession certificate, costs of executor, may also be allowed in some cases.

In case of sale of shares, you may be allowed to deduct these expenses:

• broker's commission related to the shares sold
• STT or Securities Transaction Tax is not allowed as a deductible expense.

Where jewellery is sold, and a broker's services were involved in securing a buyer, the cost of these services can be deducted.

Note that expenses deducted from sale price of assets for calculating capital gains are not allowed as deduction under any other head of the income tax return, and these can be claimed only once.

Indexed cost of acquisition/improvement

Indexed cost of acquisition is calculated as:

Cost of acquisition / Cost inflation index (CII) for the year in which the asset was first held by the seller, or 1981-82, whichever is later X cost inflation index for the year in which the asset is transferred.

Indexed cost of improvement is calculated as:

Cost of improvement / CII for the year in which the improvement took place X cost inflation index for the year in which the asset is transferred.

Refer to this page for the complete list of CII.

Section III: Exemption on capital gains

Manya bought a house in 2004 for Rs. 50 lakhs and the full value of consideration today is for Rs.1.5 crore. Since this property has been held for over 3 years, this would be a long-term capital asset. The cost price is adjusted for inflation and indexed cost of acquisition is taken.

Using the indexed cost of acquisition formula, the adjusted cost of the house is Rs. 1.06 crore. The net capital gain is Rs. 44,00,000.

Long-term capital gains are taxed at 20%. For a net capital gain of Rs. 44,00,000, the total tax outgo will be Rs. 8,80,000. This is a significant amount of money to be paid out in taxes.

This can be lowered by taking benefit of exemptions provided by the Income Tax Act on capital gains when profit from the sale is reinvested into buying another asset.

Section 54: Exemption on sale of house property on purchase of another house property

Exemption under Section 54 is available, when the capital gains from the sale of house property is reinvested into buying another house property.

The taxpayer has to invest the amount of capital gains and not the entire sale proceeds. If the purchase price of the new property is higher than the amount of capital gains exemption shall be limited to the total capital gain on sale.

The new property can be purchased either ONE year before the sale or TWO years after the sale of the property. The gains can also be invested in the construction of a property, but construction must be completed within three years from the date of sale.

In the Budget for 2014-15, it has been clarified that only ONE house property can be purchased or constructed from the capital gains to claim this exemption. Its important to note that this exemption can be taken back if this new property is sold within 3 years of its purchase.

Section 54F: Exemption on capital gains on sale of any asset other than a house property

Exemption under Section 54F is available, when there is capital gains from sale of a long-term asset other than a house property. A new residential house property must be purchased to claim this exemption.

The new property can be purchased either one year before the sale or 2 years after the sale of the property. The gains can also be invested in the construction of a property, but construction must be completed within 3 years from the date of sale.

In Budget 2014-15, it has been clarified that only ONE house property can be purchased or constructed from the capital gains to claim this exemption. Its important to note that this exemption can be taken back if this new property is sold within 3 years of its purchase.

The entire sale proceeds towards the new house will be exempt from taxes, if you meet the above said conditions.

However, if you invest a portion of the sale proceeds, the exemption will be the proportion of the invested amount to the sale price or exemption = cost of new house x capital gains/net consideration.

Section 54EC: Exemption on sale of house property on reinvesting in capital gains account scheme

Exemption is available under Section 54EC when capital gains from sale of the first property is reinvested into specific bonds.

• If you are not very keen to reinvest your profit from sale of your first property into another one, then you can invest them in bonds for up to Rs. 50 lakhs issued by National Highway Authority of India (NHAI) or Rural Electrification Corporation (REC).
• The money invested can be redeemed after 3 years; but cannot be sold before the lapse of 3 years from the date of sale.
• The homeowner has six months time to invest the profit in these bonds, although to be able to claim this exemption, you will have to invest before the tax filing deadline.

When can you invest in Capital Gains Account Scheme?

Finding a suitable seller, arranging the requisite funds and getting the paperwork in place for a new property is one time consuming process. Fortunately, the Income Tax agrees with these limitations.

If capital gains have not been invested until the date of filing of return (usually 31st July) of the financial year in which the property is sold, the gains can be deposited in a PSU bank or other banks as per the Capital Gains Account Scheme, 1988. This deposit can then be claimed as an exemption from capital gains, and no tax has to be paid on it. However, if the money is not invested, the deposit shall be treated as short term capital gains in the year in which the specified period lapses.

Section IV: Saving tax on sale of agricultural land

In some cases, capital gains made from sale of agricultural land may be entirely exempt from income tax or it may not be taxed under the head Capital Gains.

• Agricultural land in India in a rural area is not considered a capital asset and therefore any gains from its sale are not chargeable to tax. For details on what defines an agricultural land in a rural area, see above.
• Do you hold agricultural land as stock-in-trade? If you are into buying and selling land regularly or in the course of your business, in such a case, any gains from its sale are taxable under the head Business and Profession.
• Capital gains on compensation received on compulsory acquisition of urban agricultural land is exempt from tax, under Section 10(37) of the Income Tax Act.

If your agricultural land wasn't sold in any of these cases, you can seek exemption under Section 54B.

Section 54B: Exemption on capital gains from transfer of land used for agricultural purpose

When short-term or long-term capital gains is made from transfer of land used for agricultural purpose by the taxpayer or his parents for 2 years immediately prior to the sale, exemption is available under Section 54B.

The amount, investment in the new asset or capital gain, whichever is lower, that is reinvested into a new asset within 2 years from the date of transfer is exempt.

The new agricultural land which is purchased to claim capital gains exemption should not be sold within a period of 3 years from the date of its purchase.

In case you are not able to purchase agricultural land before the date of furnishing of your Income Tax Return, the amount of capital gains must be deposited before the date of filing of return in the deposit account in any branch (except rural branch) of a public sector bank or IDBI Bank according to the Capital Gains Account Scheme, 1988. Exemption can be claimed for the amount which is deposited.

If the amount which was deposited as per Capital Gains Account Scheme was not used for purchase of agricultural land, it shall be treated as the capital gain of the year in which the period of 2 years from the date of sale of land expires.