Before we go into details on how to save tax on long-term capital gains, we need to understand what capital gains are, and what the taxation regime on capital gains look like.
What is Capital Gains Tax?
Capital gains is the profit an investor makes when selling their assets for a higher price than what they purchased it for. ‘Capital’ includes property such as land, vehicles and jewellery, shares and stocks, and securities held by a person.
Capital gains are taxable, and there are 2 types of Capital Gains Tax: Short-term and Long-term. Short-term capital gains comes from the sale of property held by the investor for up to 36 months (3 years) or equity shares and bonds held for up to 12 months (1 year), while long-term capital gains is the profit made from sale of property held for more than 36 months and equity stocks and bonds held for more than 12 months.
Capital Gains Tax differs for short-term and long-term capital gains. Short-term capital gains that are not subject to securities transaction tax, are added to your income and taxed according to the income tax slabs. If the gains come under the ambit of securities transaction tax, the rate of taxation is 15% in addition to surcharge and education cess. Long-term capital gains attract a 20% tax in addition to surcharge and education cess.
Long-Term Capital Gains Tax:
Long-term capital gains (LTCG) tax for debt and equity funds are different. While equity funds attract no tax on long-term gains, debt funds attract 20% tax with indexation. Indexation refers to the process that computes the cost of the asset factoring in the inflationary price rises.
Though there are no tax exemptions on short-term capital gains tax, long-term capital gains tax are subject to tax deductions. This means that you can legally save on long-term capital gains tax by adhering to certain rules put forth under the Income Tax Act. One of the main conditions for getting exemption from paying capital gains tax is re-investment of the amount gained from the sale of the property in a residential property.
Let us take a look at the 3 main exemptions for long-term capital gains tax:
- Section 54: This concerns long-term capital gains on the sale of a house and the reinvestment of the amount received, on another house.
- Section 54EC: This concerns long-term capital gains on the sale of a house and the reinvestment of the amount received, in specified bonds.
- Section 54F: This is related to long-term capital gains on sale of any asset other than a house and the reinvestment of the amount received in buying a house.
- Capital Gains Account Scheme (CAGS): If you are unable to invest the long-term capital gains within the specified time, you can deposit the amount in a CAGS account. The amount should be used within a given timeline to build or buy another residential property.
Sell a House, Buy Another House:
Let us say you are selling a house you have owned for more than 3 years. The cost of the house when you bought it was Rs. 20 lakh, and you are selling it for Rs. 42 lakh. In this case, you make a profit of Rs. 22 lakh and you are liable to pay long-term capital gains tax on this profit amount. According to rules, you will have to pay 20% LTCG tax in addition to around 3% surcharge and cess. However, you will be exempt from paying this tax if you buy another residential property with the money you have earned from the sale of the old property.
Exemption under Section 54:
Under Section 54, you are exempt from paying LTCG tax if you buy a new house either 1 year before the sale of the old property or within 2 years of selling it. If you are planning to construct a new house, this should be done within 3 years of sale of the old property. You can get an exemption on the entire capital gains, or up to the cost of the new residential property, whichever is lower. So in the above example, if you buy a new house at a cost of Rs. 22 lakh or more, you will not have to pay any LTCG tax.
Exceptions under Section 54:
- You can get an exemption only for the purchase of 1 house. If you are using the capital gains to buy more than 1 house, you will be able to claim exemption only for the cost of 1 house.
- You can get an exemption under Section 54 only if you are buying a house in India. Any residential property purchased outside the country will not get you any exemption from paying LTCG tax.
- You cannot sell the new house bought from the gains of sale of the old house until 3 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.
Sell Your Stocks, Buy a House:
Sale of long-term assets other than a house – such as land, commercial buildings, stocks, securities, bonds, vehicles, patents and trademarks, jewellery, machinery – also give you capital gains. For example, you want to sell stocks that you have been holding for more than 1 year (in case of equity funds) or 3 years (in case of debt funds). You bought the stocks for Rs. 15 lakh, and sell it for Rs. 23 lakh. In this case, you are making a capital gain of Rs. 8 lakh. This amount can be exempt from taxation if you invest it in buying or constructing a new residential property.
Exemption under Section 54F:
Under Section 54F, you do not have to pay LTCG tax on sale of property other than a house, if you invest the amount received as capital gains to buy a new house. The purchase of the new house should be done either 1 year before the sale of the long-term asset, or within 2 years of selling it. In case you plan to construct a new house, the building should be complete within 3 years of sale of the old asset.
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. If we refer to the example above, it means that if you buy a new house at a cost of Rs. 5 lakh when your capital gains was Rs. 8 lakh, the exemption amount will be equal to: Capital Gain x (Amount Invested/Net Sale Value) = 8,00,000 x (5,00,000/23,00,000), which is equal to Rs. 1,73,913.
Exceptions under Section 54F:
The same exceptions as those under Section 54 are applicable to Section 54F – you can only buy 1 house, you have to buy the house in India, and you cannot sell the house for the next 3 years.
Sell a House or Stocks, Buy Some Bonds:
If you are selling a long-term asset but do not plan to invest in a new house, there is another way to save LTCG tax. You need to invest the capital gains in notified bonds. These bonds are usually issued by government bodies such as Rural Electrification Corporation (REC) and the National Highways Authority of India (NHAI), and the interest rate is 6%. The interest gained is not exempt from tax.
Exemption under Section 54EC:
Under Section 54EC, you do not have to pay LTCG tax on sale of any long-term capital, if the amount received as capital gains is invested to buy specific notified government bonds and securities. The bonds should be bought within 6 months of the sale of the asset. The maximum amount you can invest in this way is Rs. 50 lakh. However, this investment is restricted to a single financial year. If the 6-month period is spread into 2 financial years, then you can invest Rs. 50 lakh twice – i.e. you can claim tax deductions of up to Rs. 1 crore. For example, if you sold your asset in January 2016 and got capital gains of Rs. 75 lakh, you can buy notified bonds worth Rs. 50 lakh in February 2016 and invest the remaining Rs. 25 lakh in bonds in April 2016 to avail full exemption.
Exceptions under Section 54EC:
- You are eligible for an exemption only if you invest in the notified bonds and securities. Talk to your taxman for details.
- This exemption will be withdrawn if you sell these bonds within 3 years of purchasing them.
- This exemption will be revoked even if you take a loan on these bonds within 3 years of purchase.
Deposit in Capital Gain Deposit Account Scheme:
Capital Gain Deposit Account (CGDA) Scheme, 1988, is complementary to Section 54 and Section 54F. If you are unable to utilise the entire capital gains made in a transaction till the date of filing Income Tax Return, then you can deposit the unutilised amount under the CGDA Scheme in any public sector bank. Once the money is deposited in this account, you need to use it within 2 years (in case of purchase of a new house) or 3 years (in case you are constructing a new house).
You have to open the account before the deadline to file I-T return, and the money must be used only to buy a residential property. If the money is not utilised in buying a house within the time limit, the capital gains will be subject to tax.
Sale of a long-term capital often gets you high profits because of the increasing inflation and cost every year. If you invest the profits well, you can save yourself 20% of the amount which otherwise would go to the government as tax.