What is capital gains tax? How to avoid capital gains tax on sale of property?

One thing that we all want to achieve while selling the property is to minimize our tax liability.

Aug 20, 2019 09:08 IST India Infoline News Service

Capital Gain Tax
Owning real estate comes with its set of trials and tribulations. Selling it requires a lot more due diligence. You have to make sure you are selling the house at a reasonable profit, then there are brokerage fees that you have to contend to, transfer of documents, and so on, all of which makes the whole process very tedious.
 
One thing that we all want to achieve while selling the property is to minimize our tax liability. Sale of property attracts capital gains tax.
 
Let us look at the ways in which we can reduce or avoid the capital gains tax.
 
First, let us address the basic question:  
 
What is capital gains tax?
 
Capital Gains Tax or CGT is defined as the implication of tax over the realized profits of the sale of an asset, especially a non-inventory asset, such as property, bonds, stocks, or precious metals. The CGT is payable on the excess amount realized at the time of sale of the asset as compared to its cost of acquisition. In other words, CGT is levied on the profits realized by an investor when he or she sells the capital asset.
 
Such CGT applies in the following circumstances:
  • The asset is purchased at a lower cost than the sale price of the asset. 
  • The asset is sold at a higher price than the cost of acquisition of such assets. 
  • The asset transferred is a capital asset. 
What does not qualify as a capital asset?
  • Stock held for business 
  • Personal possessions (Excludes jewelry, paintings, archaeological collections, sculptures, or any other work of art which will attract CGT) 
  • Rural agricultural land
 
The profit earned through the sale of property is taxable in the financial year during which the transaction is completed. In case an asset is inherited, there are no capital gains because there is no sale, just a transfer of ownership. However, if you sell an inherited capital asset, there is an instance of capital gains.
 
The Income Tax (IT) Act exempts assets that are received as gifts through a will or inheritance. CGT would not apply if a property holder sells his property at the same or lower price as compared to its cost of acquisition.
 
There are two types of capital gains tax-
  1. Short-term capital gains tax (STCG) 
  2. Long-term capital gains tax (LTCG)
 
A. STCG:  If the property is sold within 24 months from the date of acquisition, any gain from the sale proceeds will be termed as short-term capital gain. Short-term capital gains are added to your income and you have to pay tax as per your income tax slab. For e.g., if you are in 30% tax slab, your short-term capital gains will be taxed at 30%.   
  • How do you save tax on STCG?
It is a lot more difficult to circumvent STCG. However, there are a few things that will help reduce your STCG liability. These are 
  1. You are allowed to adjust your sale consideration for any brokerage, commission you may have incurred at the time of property sale. 
  2. You can deduct any construction and home improvement expenses incurred during the period you held the asset.
 
Thus, your STCG can be calculated as follows:
 
STCG = Sale Consideration – (Cost of Acquisition + Cost of Improvement + Cost of Transfer)
 
B. LTCG: If more than 2 years have passed between the date of purchase and sale of an asset, your gain from the sale will be classified as a LTCG. LTCG is taxed at 20% + surcharge and education cess with indexation benefit and 10% without indexation. LTCG is calculated as the difference between net sales consideration and indexed cost of property. The benefit of indexation is allowed to set off the impact of inflation from the gains made on sale of the property so that the actual gains on property will be taxed.
 
What is indexation?
 
Inflation erodes the value of the asset over time. For example, the real value of Rs3,000 after 5 years, assuming an annual rate of inflation of 5%, would be Rs2,321. Hence, it must be taken into account when computing tax on the difference between the buy and sell cost. Indexation takes inflation into account during the holding period of the asset and raises its acquisition price accordingly. This reduces the overall gains, and consequentially, pulls down tax outgo. Indexation allows for inflating the purchasing price of an asset taking into account the cost inflation index (CII), in effect reducing the taxable corpus.  The CII is updated by the Reserve Bank of India every financial year.
 
LTCG can be calculated as follows:
 
LTCG = Sale Consideration – (Indexed Cost of Acquisition + Indexed Cost of Improvement + Cost of Transfe r+ Exemptions)
  • How can you save tax on LTCG?
There are certain provisions available that will help you save tax on LTCG. They are
 
a) Under section 54: LTCG arising from the sale of an immovable property is exempt from tax if the sum is used to acquire a single residential property, within the stipulated timeline. These are 
  1. The assessee needs to buy the new property within one year before the date of transfer of the property. 
  2. Or the assessee needs to buy the new property two years after the transfer. 
  3. In case of under-construction properties, the construction needs to be completed within three years from the date of transfer. 
b) Under section 54EC: This is a good option for tax payers who have sold their properties, but are unable to take benefit from the rules under section 54 by buying another residential property. Such tax payers have the choice of investing their gain in specified bonds. However, the total investment limit in these bonds is restricted to Rs50 lakh to avail the benefit. However, there are a few considerations you have to keep in mind: 
  • You have to invest the capital gains within 6 months of selling your property. 
  • TDS is not applicable on money invested in capital bonds. Although, interest income from capital gains bonds is taxable. The tenure of capital gains bonds is 5 years and the redemption is automatic. You will not get any interest after 5 years. 
  • Bonds issued by the National Highway Authority of India (NHAI) or Rural Electrification Corporation (REC) have been specified for this purpose. These bonds earn you an interest of 5.25% per annum 
c) Under section 54GB: LTCG from the sale of a residential property becomes tax-free if the sale proceeds are invested in a small or medium enterprise in the manufacturing sector. There are some considerations:
  • Such investment can be made anytime within six months from the date of transfer of assets. 
  • The funds have to be used by the company to acquire new plant and machinery before the due date to furnish tax returns for the relevant financial year. 
  • The equity holding or voting power of the assessee after the investment should be more than 50% in the firm.
 
Investing in Capital Gains Account Scheme: If the tax payer is unable to use the sale proceeds immediately, he/she can deposit the amount in a Capital Gains Account Scheme (CGAS).  The amount has to be parked in CGAS with the intention to use the funds to buy a new house within two years or to construct one within three years of the deposit.

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