If you have sold any capital asset, like a house property, at a profit, it may not be time to rejoice just yet. Sale of capital assets comes with a string attached, i.e. the capital gains liability.
If the asset has been sold within 36 months from the date of purchase, a short-term capital gains liability arises; alternatively a sale after a 3-year period is subject to a long-term capital gains liability.
Let us take an example to understand this. Suppose you had purchased a house property in March 1994 for Rs 10,00,000 and sold the same 10 years hence in March 2004 for Rs 25,00,000. Your profit would be Rs 15,00,000; after factoring in the benefits on account of indexation the same would be Rs 602,459 (See Table 1).
The tax rate for long-term capital gains is 20 per cent; hence, the tax liability would be Rs 120,492.
Cost of Purchase (Rs)
Sale Proceeds (Rs)
Date of Purchase
Date of Sale
Cost Inflation Index for the year of purchase
Cost Inflation Index for the year of sale
Sale Proceeds (Rs)
Less: Indexed Cost of Purchase (Rs)
Long term capital gains chargeable to tax (Rs)
Long term capital gains tax @ 20%
Now let us examine some of the options available to the assessee in the given situation:
1. Invest in capital gains bonds
Assesses can avoid paying long-term capital gains tax by investing the profit on sale (i.e. Rs 602,459 in the case above), in capital gains bonds within a stipulated period of time.
These bonds are issued by specified institutions and the benefit is available under Section 54EC of the Income Tax Act. Investments should be made within a period of 6 months from the date when the capital asset was sold.
Investors are required to stay invested in the 54 EC bonds for a 3-year period from the date of investment. Failure to do so negates the tax benefits claimed.
In Table 2 we have demonstrated the working of these bonds. The Rural Electrification Corporation Ltd offers 5-year bonds with a coupon rate of 5.15 per cent for the first 3 years. Investors have the liberty to redeem their investments at the end of 3 years without any adverse impact on the tax benefits claimed.
After factoring tax benefits, capital gains bonds deliver a return of 13.27 per cent on a CAGR basis. While the returns may not seem very lucrative as compared other options, if not paying taxes is of vital importance to you, this investment makes a lot of sense.
Amount invested (Rs)
Tax saved at time of investing (Rs)
Maturity proceeds (Rs)
3-year CAGR Returns*
Source: http://www.personalfn.com. * Returns adjusted for tax benefits
2. Pay tax and invest in other avenues
Some might believe that investing in capital gains bonds is not a smart proposition since it involves blocking a significant sum of money and fails to deliver proportionate returns.
In such a scenario, you can consider paying up tax and investing the balance profits in avenues like mutual funds.
The 3-year performance for categories like diversified equity and balanced funds is undeniably an impressive one. Despite the fact that the 3-year period is a good indicator, historical returns are simply that, historical!
Secondly, investing in equity-oriented schemes also involves taking on higher risk. For those who attach greater importance to returns vis-à-vis tax saving and have the stomach to take risk, mutual funds can be a rewarding option.
Diversified Equity Funds
HDFC Top 200
Franklin India Bluechip
HDFC Prudence Fund
DSP ML Balanced
FT India Balanced
Source: Credence Analytics; * Returns are Compounded, Annualised
NAV data as on October 29, 2004
3. Invest in a residential property
Long-term capital gains can be employed to acquire a residential property. If the requisite conditions including the time duration within which the gains have to be invested in buying/constructing a property are fulfilled, the assessee is exempt from paying any capital gains tax.
Similarly the new property should not be transferred within a 3-year period from the date of original transfer or construction; else the amount of capital gains claimed as exempt will be treated as being taxable in the year of transfer.
Detailed provisions governing this clause can be found under Sections 54F and 54H of the Income Tax Act.
As you would have realised there is more to managing capital gains liability than just investing in tax-saving bonds.
Adopt a strategy that best suits your needs and serves your interests; and capital gains tax management won’t be another dreary tax-planning chore.
This article forms a part of the latest issue of Money Simplified – The Definitive Guide to Tax Panning. Click here to download, for FREE, the complete guide.