Saving Capital Gains Tax on Property Sale

Introduction

Investment in property has long been an attractive and safe option for many. When it comes to reaping the benefit of the growth in its value by selling, investors hesitate due to the tax implications that come with it. There are ways to minimize this tax bill and in this article, we will discuss one such way.

If one sells the property within two years of purchase, then any gains earned through the sale would be treated as short-term capital gain and will be taxed depending on one's tax slab.

In order to be able to take benefit from the section discussed in this article, the property needs to be sold at least two years after the purchase. Any gains made on such a sale will be categorised as a long-term capital gain. In this situation, one can use section 54, which brings the benefit of indexation. This indexation will help reduce the tax bill on any profits made from the sale.

The holding period for claiming capital gains tax exemption

The law imposes restrictions with respect to the purchase time, location, and holding period of the new property. Firstly, the new property should be purchased one year before the sale or two years after the sale of the main property. In case, one is building on their own, the construction should be completed within three years of the sale of the property. Secondly, property buying or building must happen within India.

The benefits of tax relaxation would be reversed if the new property is sold within three years of purchase and the profit earned from the sale will be treated as a short-term capital gain.

Reinvestment requirement

The entire profit must be reinvested in the new property to claim exemption on the entire long-term capital gain amount. If this is not done, the exemption will be limited to the amount re-invested.

For example, let's consider the profit earned by an investor on a property sale was ₹20 lakhs. The entire amount of ₹20 lakhs will be tax-free if it is entirely invested in buying a new property. In case only ₹15 lakhs were reinvested in a new property the remaining ₹5 lakhs would be taxable.

Cost of the property

The cost of the property is not only the amount paid to the seller. All charges associated with the purchase, such as stamp duty, registration charges, and brokerage fees should also be included in the cost of the property. This way one can increase the deduction limit.

Also, any expenditures made to improve the property such as any repairs and renovations can be added to the overall purchase cost while computing long-term capital gains.

Indexation benefits on capital gains tax on the sale of property

For the uninitiated, indexation is the process of adjusting the purchase price of the property for inflation. Indexation allows the seller to factor in the impact of inflation on the historical cost of acquisition. This, effectively, lowers the amount on which capital gain tax will be charged. In the absence of this benefit, the tax will be charged on a much higher amount. The long-term capital gains tax is calculated by deducting the index cost of the house from its net sale price. The seller is entitled to avail of indexation benefits on long-term capital gains.

Let's see an example. If one had bought the property in 1994-95 at ₹20 lakhs and sold it in 2015-16 for ₹1 crore, without indexation the long-term capital gains would be ₹80 lakhs. However, because of indexation, the magnitude of this gain will be much smaller. The below calculations will provide an idea of how to use indexation and how much will the capital gains be because of it.

First, let's establish the formula for Capital gains.

Capital gain = Selling price - Indexed cost of acquisition

Next, let's see the formula for indexed cost, which is

Indexed cost of acquisition = Purchase price * (Index in the year of sale ÷ Index in the year of purchase)

Now, the index in 1994-95 was 259 and it increased to 1,081 in 2015-16. Therefore the price of acquisition at the time of the sale taking into account the indexation will be calculated as 

₹20 lakhs * (1081÷259) = ₹83.48 lakhs

This means the long-term capital gains will be ₹1 crore - ₹83.48 lakhs = ₹16.52 lakhs. That is just about 21% of the ₹80 lakhs, which would have been considered as capital gains had indexation not been considered.

This way section 54 can help greatly reduce the tax bill on the sale of the property.

Note: Above details are meant for generalized situations and shall not be used as a legal basis for any particular situation readers may have. We do provide tax consultations for specific scenarios and can be reached through our contact us form.

---

Comments (0)

Sign up or Login to comment

Be the first to comment