How to Save Capital Gains Tax on Sale of Residential Property?
January 2023
Discussed in this article are ways in which a property seller can lower his tax liability arising from capital gains made on the transaction
Property owners in India have to pay capital gains tax on sale of residential property. The logic behind the capital gains tax on sale of residential property — the sale of property typically results in profits for the owner.
What is capital gain?
Capital gain is the increase in the value of an asset over a time period. This capital gain is realised by the owner at the time of the sale of the asset. Capital gain is basically the difference between the selling and purchase price of an asset.
Factor that determine capital gains tax on sale of property
In the words of former American president, late Theodore Roosevelt, every person who invests in well-selected real estate, in a growing section of a prosperous community, adopts the surest and safest method of becoming independent, for real estate is the basis of wealth. So, capital gains tax is levied on sale of residential property. The factors that determine the capital gains tax on property sale include:
Cost of property
Cost of property includes the money spent on its acquisition (including brokerage charge, stamp duty and registration charge), as well as money spent on its improvement and renovation. So, if a property was bought for Rs 50 lakh and subsequently Rs 20 lakh was used to renovate it, the total cost of property for tax computation purposes would be Rs 70 lakh.
Cash payment for property improvement
The Mumbai Bench of the Income Tax Appellate Tribunal (ITAT) has ruled that property sellers, who spend cash on home improvement, can include this amount to compute the overall property cost, when computing their capital gains tax liability on property sale. In this case, one Komal Gurumukh Sangtani approached the ITAT after the assessing officer refused the deduction for the cost of improvement of the property when computing capital tax liability. In cases where such payments have been made in cash, the taxpayer will, however, have to prove that no unaccounted money was used to make the payment. He will also have to explain the source of the cash payments made for the improvement works, to claim relief in tax liability.
Holding period for capital gains
Under the existing Indian IT laws, the holding period – the time for which you remain the owner of the property before you sell it – plays a determining role in deciding the tax liability. If the law perceives the transaction to fall under the category of short-term capital gains (STCG), the tax liability will be higher. However, if the transaction falls in the long-term capital gains (LTCG) category, you will be charged 20.8% of the profit in taxes. The 20.8% LTCG tax is applicable, irrespective of your tax slab.
Another important thing to note, is that a tax payer is allowed several rebates under the provisions of the IT Act, in case the transaction is treated as LTCG. In case of STCG, the scope to lower the tax liability is almost non-existent – the tax payer can only set off the gain against any short-term loss from the sale of assets like stocks and gold, etc.
Investment in new property
Your tax liability will be considerably low and akin to zero, if you reinvest the sales proceeds of the old property into a new one, within a specific period, subject to certain terms and conditions.
Latest update: In a circular issued on January 6, 2023, the Central Board of Direct Taxes (CBDT) has extended the deadline for making these investments. According to an the notification, for investments that had to be made between April 1, 2021, and February 28, 2022, the deadline is now extended to March 31, 2023.
Property ownership
The tax liability is always higher for a seller who owns multiple properties. The same is not true in case of someone who owns only one property. We shall examine the specific provisions that establish this, in the later part of this article.
How to save capital gains tax on property sale?
Let us discuss the options available to sellers, to save capital gains tax on property sale.
Section 54 on purchase of new property
If you sell a property within two years of the purchase, the gains you earn though the sale would be treated as STCG and will be taxed, depending on your tax slab.
The applicability of deductions offered under Section 54 will arise, only when you sell the property after two years of purchase, thus, earning profits under LTCG. In this case, while the profits will be taxed at 20.8% along with indexation benefits, Section 54 will help you get relaxations, if you follow certain conditions. These include:
Number of houses you can invest in for capital gains exemption
You can reinvest the capital gains from the property sale in buying or constructing up to two houses. It is pertinent to recall here that the exemption was limited to only one property before the Budget 2019 extended it to two properties. In case you are reinvesting the proceeds in two properties, the deduction will only be available if the capital gains on the sale of the property does not exceed Rs 2 crores. The seller must also be mindful that he can claim this benefit only once in a lifetime.
Holding period for claiming capital gains tax exemption on property sale
The law also 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 you are building the house on your own, the construction should be completed within three years of sale of the property. Secondly, this property you are buying or building must be situated in India.
The relaxation in tax would be reversed, if you sell the new property within three years of its purchase. The profit earned on this sale will also be treated as short-term capital gains.
The entire profit must be reinvested in the new property, to claim exemption on the entire LTCG amount. If this is not so, the exemption will be limited to the amount re-invested. Suppose, you earned Rs 20 lakhs as profit on the sale. The entire amount will become tax-free, if you reinvest Rs 20 lakhs to buy a new property. In case you only spend Rs 15 lakhs on the new property, the remaining Rs 5 lakhs would become taxable. All the associated charges included in the purchase of the new property, i.e., stamp duty, registration charge, brokerage fee, should be included in the cost of the new house in order to increase the deduction limit. Similarly, money spent on repairs and renovation can be added to the overall purchase cost, while computing LTCG.
The capital gains exemption is valid under Section 54, if you have taken a home loan to buy the new property or repay the home loan for the old one.
Indexation benefits on capital gains tax on sale of property
For the uninitiated, indexation is the process of adjusting the purchase price of the property, for inflation. The indexation benefit allows the seller to factor in the impact of inflation on the historical cost of acquisition. This, effectively, lowers the amount on which capital gains tax will be charged. In the absence of this benefit, the tax will be charged on a much higher amount.
The LTCG tax is computed, by deducting the indexed cost of the house from its net sale price. You are entitled to avail of indexation benefit on long-term capital gains. If you bought a property in 1994-95 at Rs 20 lakhs and sold it in 2015-16 for Rs 1 crore, your long-term capital gains will not be Rs 80 lakhs. Instead, it will be calculated as follows:
Capital gain = Selling price – Indexed cost of acquisition.
Indexed cost of acquisition = Purchase price x (Index in year of sale/Index in year of purchase).
Now, the index in 1994-95 stood at 259 and in 2015-16 at 1,081.
Hence, your indexed cost of acquisition will be = 20 x (1081/259) = 83.48
Your long-term capital gains will be = 100 – 83.48 = 16.52 lakhs.
Exemptions under Section 54 EC on purchase of specific bonds
Sellers do not necessarily have to reinvest the sales proceeds of their property into realty, to claim deductions. They could also do so by reinvesting the money in specific bonds.
Section 54EC allows exemption of LTCG on sale of land and building, if the profit is reinvested in certain specified bonds, within six months from the date of sale of the house. Section 54EC-specified bonds include those issued by the Railway Finance Corporation, the National Highways Authority of India, the Rural Electrification Corporation, etc. Note that the upper limit is capped at Rs 50 lakhs, for this investment with a lock-in period of five years.
More importantly, this exemption is available on sale of residential, as well as non-residential properties. The interest earned on these bonds, which is 5.25% annually, is entirely taxable. However, the maturity proceeds of the bonds are fully tax-free.
Exemptions under Section 54GB
Section 54GB exempts the profits categorised as LTCG on sale of house or plot, if the proceeds thus earned are invested in the subscription of equity shares of eligible companies. The exemption would be available, if the profit is reinvested in small or medium enterprises or in eligible start-ups. If you are buying computers and other such equipment for your start-up with the sales proceeds of a house property, you could claim deductions under this section.
In any case, the holding period for the new asset has been capped at a minimum of five years. Open only to individuals or Hindu Undivided Families (HUFs), the exemption under Section 54GB could be availed, if the tax payer utilises the net consideration before the due date of furnishing the income tax return.
Setting off capital gains against losses
Another option available to property sellers, to reduce tax liability on property sale, is to set off the LTCG from the sale of the house against any long-term loss from the sale of other assets, including stocks and gold. These could be the losses carried forward in the last eight years, along with the losses incurred in the year in which you are claiming the benefit.
Capital gains tax on sale of property: Factors sellers must keep in mind
* In case you invested in a housing project which is stuck for some reason and the developer has not been able to offer possession, you are still allowed to claim the exemptions under various sections of the tax law.
* Depending on the holding period, the profit on the transaction will be treated as STCG or LTCG and taxed accordingly. Similarly, the relaxations under Section 54 and Section 54EC will apply.
* A property cannot be registered below a certain value as specified by state government authorities. Even if you agree to sell the property for a lower price, its registration would still be done at the minimum registration value allowed in that area. The entire tax liability will be calculated, depending on the property’s value as determined by the sub-registrar’s office.
* If you are neither able to invest the sales proceeds earned from the transaction into buying another property nor able reinvesting the fund into specified bonds, the balance amount should be deposited in the Capital Gains Account Scheme. This way, you will remain eligible to claim deductions.
Things to avoid when selling a property
* In your best interest, the transaction must be reported to the tax authorities and all dues must be paid in a time-bound manner. You do not want to get caught in legal hurdles later.
* In some case, the buyer may insist on paying part of the deal amount through unaccounted channels. Even though it may help you to save on taxes, it also means that the registered value of your property will be less. If you were to sell it in future, you may have to take a loss.
Source: housing.com
Also read: What is house rent allowance or HRA?
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