Capital gains tax on property decoded

Last week we examined tax incidence on rental income. This time we shall look at the other income stream that immovable property can generate - capital gains.

Basically, when property is sold, depending upon the holding period, one will earn either short-term or long-term capital gains. If the property is sold after three years of owning it, the gain will be long-term, else it will be short-term.

The tax rate on long-term capital gains is 20.6% of the profit after indexation of cost. The option of paying tax at 10% without indexation is only available in the case of financial assets like mutual funds and the like; it is not available in the case of immovable property - for property, the tax has to be calculated at 20.6% post indexation.

Indexation of cost basically refers to a facility that a taxpayer can use to inflation-adjust the cost. In other words, indexation factors in inflation during the holding period by adjusting the cost of acquisition upwards thereby bringing down the tax liability of the investor.

Putting it differently, the value of the rupee say 10 years ago wasn’t the same as the value currently - essentially on account of inflation. So if you are asked to pay tax on your profits derived out of a simple arithmetic of reducing actual cost from the sale proceeds, it would be unfair. Simply because the sale proceeds are derived out of the current value of the rupee, whereas the cost you paid was based on the value of the rupee as existed 10 years ago in this case.

Therefore, the income tax department releases what is called a cost inflation index (CII) for each financial year. This is done expressly for inflation adjusting the cost. For the purposes of calculating the capital gain, the cost will be multiplied by the CII pertaining to the year of sale and divided by the CII of the year of purchase. This essentially adjusts or inflates the cost to current levels thereby reducing the amount of capital gain than what would have resulted from a simple subtraction.

In terms of an example, say a property was bought in the FY 2000-01 for Rs50 lakh. The same is being sold now for Rs2 crore. A simple arithmetic subtraction would result in a long-term capita gain of Rs1.50 crore. Now, let’s adjust for inflation and see what results.

The CII for FY 2000-01 as declared is 406 and for current year, it is 785. If the cost is adjusted with the ratio, the revised cost would work out to be Rs97 lakh, thereby bringing the capital gain amount down to Rs1.03 crore. The net saving in tax at 20.6% is a whopping Rs9.6 lakh

Now, the next step would be to try and save this tax. Tax can be saved if so desired by doing either of the following two things:

a. Invest in specific capital gains tax saving bonds. These bonds are currently being issued by NHAI and REC. If the entire amount of long-term capita gains is invested in these bonds, the tax is fully exempted. Investment of any lesser amount will grant a proportional deduction. There is a lock-in period of three years for the bonds after which the money can be withdrawn. However, there is a ceiling of Rs50 lakh on investment in these bonds and the way property prices are ruling currently, this limit might just fall short of the actual requirement.

b. Invest in another residential property. There are two points to note here. First, how much to invest - in case the asset sold is a residential house, the taxpayer has to invest the calculated capital gain amount in the new property. On the other hand, if the asset sold is not a residential property, i.e. say its commercial property or a plot of land etc, the net sale proceeds (as against the capital gain amount) have to be invested. The difference is extremely significant - the calculated capital gain amount could be much lesser on account of the reduction of indexed cost, whereas, the net sale proceeds is well just that - the sale proceeds net of brokerage and other incidental costs.

The other significant point is that the new asset has to be a residential house. In other words, when you sell a property, depending upon the nature of the asset (whether residential property or otherwise), the tax can be saved by investing the capital gain amount or the net sale proceeds, as the case may be, in a new property and this new property has to be a residential house. This means, you cannot invest in a commercial property or land to save tax - you have to necessarily buy residential property only.

Now, you will appreciate that buying property is very different than investing in bonds. For making a financial investment, all you need to do is fill out a couple of forms - sign those and cut out the cheque. But buying a house can be much long drawn out. It’s a big ticket purchase. First, you have to identify a suitable property.

Once that is done, you also have to check if the title is clear and that the property is free of any other encumbrance - all this due diligence is time consuming.

Which is why the law gives a taxpayer two years from the date of sale to identify a property and invest in it. If the property is under construction, the two-year period is further enhanced to three years. However, before that comes the time to file the tax return.
Now, if a property hasn’t been identified and purchased before the return has been filed or before the due date for filing the tax return, whichever comes earlier, the money has to be deposited in a special account known as the Capital Gain Account Scheme (CGAS) - doing this indicates to the authorities that you intend to buy a property to save the capital gain tax. Any withdrawal from CGAS should only be for payments to be made in relation to the purchase of the new property.

Lastly, the new property purchased has to be held for a minimum period of three years failing which the capital gains arising from the sale of the new property together with the amount of capital gains exempted earlier will be chargeable to tax in the year of sale of the new property.

— The writer is director, Wonderland Consultants, a tax and financial planning firm. He can be reached at sandeep.shanbhag@gmail.com