How to minimise the effect of taxation on long-term capital gains

Capital gains can be defined as improvement or profit accruing from the sale of a capital asset. This is subject to tax, provided there is an actual transmission of the capital asset. However, if an asset is inherited, no sale is considered to have taken place; one individual has simply transferred an asset to another.

Of course, if there is a proper sale of an asset to any other person who inherits it, then capital gains tax comes into play. But the Income Tax Act unambiguously excludes assets accredited as gifts by way of a will. An asset if retained for more than 36 months will be counted as a long-term capital asset. From FY 2018-19 the norm of 36 months has been reduced to 24 months, but only in case of fixed property such as land or building/house property.

Here’s an example. If you as an individual traded any property after keeping it for a period of 24 months, the income you got from it will be considered a long-term capital gain, but with a condition that you must have sold that property after 31 March 2018. But let us not get confused that such alteration is never applicable to any property such as debt-oriented MFs or jewellery, etc. If you held it for more than 36 months, it will be counted as a long-term capital asset.

Things that will be considered as long-term capital assets if held for more than 12 months:

Equity or preference shares in a company listed on a recognised stock exchange in India
Securities computed on a standard stock exchange in India
Units of UTI (applicable in both the conditions whether quoted or not)
Units of the equity-oriented mutual fund, no matter whether it is cited or not
Zero coupon bonds (no matter whether quoted or not)
Note: As mentioned earlier, if an asset is obtained by gift, will, or inheritance, the period one has held this asset determines if it’s a short-term or a long-term capital benefit. In the situation of rights shares or bonus shares, the calculation is made depending upon the duration of holding, starting from the date of allotment of bonus shares.

How LTCG is taxed

To compute the LTCG tax payable, one can use the given formula:

Long-term Capital Gains = full cost of the consideration assimilated or accruing minus (indexed cost of acquisition + indexed cost of improvement + price of transfer)

Note: Indexed cost of acquisition = cost of acquisition x cost inflation index of the year of transfer/purchase

Indexed cost of improvement = cost of improvement x cost inflation index of the year of transfer/ improvement

What is indexation?

Indexation is the procedure of regulating prices grounded on a typical index factor in the inflation rate while computing profits received on sale of assets. It has got great significance as the prices usually do not stay flat and tend to fluctuate with time; hence calculating profits as per the original amount of an asset is not an exact measure of profit. This process takes inflation into consideration and helps in getting a precise figure for long-term capital gains.

Example of taxation on LTCG (real estate)

Using Indexation

Let us consider a scenario where you bought a plot of land for Rs 10,00,000 in 2005. Now, after the completion of 10 years, in January 2015, let’s assume you sold this property for Rs 30,00,000. Now, the calculation goes like this:

Cost Inflation Index (CII) = Index for FY 2014-15/Index for FY 2005-2006 = 1024/480 = 2.13

Indexed cost of purchase = CII x purchase price = 2.13 x 10,00,000 = Rs 21,30,000

Long-term capital gains = Selling price - indexed cost = 30,00,000 - 21,30,000 = Rs 8,70,000

Tax on capital gains = 20% of 8,70,000 = Rs 1,74,000

Tax on capital gains without indexation (for stocks and mutual funds)

There is an alternative to the complex path of indexation; one can directly compute capital gains tax. In this event, merely 10% of the capital gains that is not indexed is charged as tax. Individuals can choose to practice indexation and pay 20% tax or even overlook indexation and pay 10% on their capital gains.

How to save tax on LTCG

Tip 1: Invest in residential property within a specific time (Section 54/ 54F)

As per income tax provisions, LTCG ascends from the sale of a capital asset can be relieved under Section 54/54F provided the net sale proceeds are capitalised in the buying or construction of a residential property, but subject to the given conditions:

Condition (i): You would be required to use the funds from the capital gains in purchasing a new residential property right before a period of one year or two years after the sale/transfer of the original property.
Condition (ii): You must invest the money in an under-construction housing property or construct a residential property, provided that the building gets finished in three years right from the date of sale/transfer of the original property.
Condition (iii): You as an investor must not own any other property except the new house right on the day of sale, neither should you build any residential house for three years after the sale date.
Condition (iv): In case the sum you devoted to buying the new property exceeds the capital gains, the maximum amount of tax freedom is limited to the proceeds from LTCG invested in the purchase. In other words, the maximum exemption cannot surpass the sum of LTCG made.

Tip 2: Invest in Capital Gains Account Scheme (CGAS)

It is recommended to reinvest the capital gains in a residential property right before you file IT returns for the current year. If you are not able to buy the right property before the due date (usually July 31) of filing a tax return; the unutilised sale proceeds can be put into a Capital Gains Account Scheme (CGAS). Please note that to avail of exemption under CGAS, the amount of capital gain, or net consideration, must be placed before the final date for filing IT returns.

Tip 3: Invest in bonds (Section 54 EC)

The transfer of any long-term capital asset is exempted under section 54EC, provided you invest the capital gains within six months in notified bonds provided by the National Highways Authority of India (NHAI) or Rural Electrification Corporation (REC) for a minimum duration of three years. These bonds are referred to as capital gains bonds.

To claim exemption from LTCG tax, try to invest in capital gains bonds right in the initial six months from the date of sale of property, or the due date of filing IT returns (typically July 31), whichever is earlier.

Conclusion

Many market leaders believe that the obligation of LTCG tax could help the government earn Rs 20,000 crore by way of revenue in the next year. Says Dr VK Vijayakumar, Chief Investment Strategist at Geojit, “Fiscal slippage to 3.5 % from the target of 3.2 % along with 10% tax on LTCG may look negative, but at the same time the grandfathering of LTCG on acquisitions till 31 January 2018 is a welcome move.”

It is important to stay informed of beneficial tax provisions as it relieves taxpayers from substantial tax liability. All one needs to do is make sensible investments at the right time.

- Vikas Agarwal

Vikas Agarwal is an IIT-Varanasi graduate in Chemical Engineering. He is the Founder and CEO of Finaacle.com and a Business Development Professional but a Value Investor at heart. He writes articles on Finaacle, which focus on simplifying the art of investing and the causes of human misjudgment when it comes to investing. He also shares his experiences as an investor and lessons from some of the greatest investors of all time.

Disclaimer: This article is intended for general information purposes only and should not be construed as investment or insurance or tax or legal advice. You should separately obtain independent advice when making decisions in these areas.