You must use capital gain bonds to save on long-term capital gains tax

A client, Mahesh, had the good fortune to recently sell off a plot of land that he had inherited from his father. The amount of taxable long-term capital gains made by him was approximately Rs 80 lakh on sales proceeds of Rs 1 crore. He ideally wanted to utilise the sales proceeds from the land in his business but at the same time, he wanted to save on the long-term capital gains tax (LTCGT) of around Rs 16 lakh as well. One of the options he was considering to claim full exemption from paying LTCGT was to invest the entire sales proceeds of Rs 1 crore in a flat that he planned to give on rent for a period of 3 years and then sell to have his money released for use in business. The second option he was considering was to buy capital gain bonds of Rs 50 lakh from either NHAI or REC to be able to claim an exemption for a like amount of long-term capital gains and restrict the purchase price of flat accordingly.

He sought my advice and I, without hesitation, recommended the second option. In his case, the economics was clear. He was claiming LTCGT exemption under section 54F that requires investment of entire sales proceeds (and not just the capital gains portion), which means the entire sales proceeds of Rs 1 crore would be blocked for 3 years with post-tax rental return of about 2% per annum and an uncertain capital gain (if at all) after 3 years due to the huge upfront cost such as stamp duty, etc. of around 10% incurred upfront. Additionally, he would have hassles of finding and managing a tenant for 3 years and then finding a buyer after 3 years. On the other hand, if he invested in the 6% capital gains bonds for Rs 50 lakh, he would get a hassle-free, risk-free post-tax return of around 5% p.a. for 3 years and the money would automatically get credited to his bank account after 3 years.

Additionally, he would then need to invest only Rs 37.50 lakh in the new flat for claiming complete exemption from LTCGT. This would leave him with Rs 12.50 lakhs (Rs 1 crore sales proceeds minus Rs 50 lakh invested in capital gains bonds minus Rs 37.50 lakh invested in the new flat) to be invested in his business with full exemption from LTCGT. This Rs 12.50 lakh meant a lot for Mahesh as he was paying interest @12% for the overdraft facility that he had taken for his business purpose and this amount would help him save on interest on that amount. Like Mahesh, almost any person liable to pay LTCGT is bound to benefit by buying capital gain bonds and reducing the cost of the new flat accordingly. The only exception I can think of is if the new flat has already been bought prior to the transfer and its cost is enough to exempt the entire LTCGT or if the new flat to be bought is not an investment asset and is meant for own use and its cost is anyways enough to fully exempt LTCGT.

A supplementary query that Mahesh had was on when to buy the capgain bonds - Should he buy immediately or wait for 6 months? In his case, the return for waiting was quite high at 12% (the overdraft interest rate) and hence I, counselled him to wait but in most cases, if your possible return during the intervening 6-month period is low, it is best to buy the bonds immediately after the transfer date.

The benefits of capgain bonds to shield LTCGT works similarly even if the transferred asset is a residential flat and only the capital gains portion of the net sales proceeds have to be invested in the new flat to claim full LTCGT exemption.

In summary, capgains bonds should be your first choice to shield LTCGT before considering any other option.

Exemption under section 54F is calculated as under:

Cost of new flat divided by net sales proceeds multiplied by the capital gains
Rs 37,50,000 divided by Rs 1 crore multiplied by Rs 80 lakh is Rs 30 lakh.