Saving Capital Gains Tax on Residential Property Sales

Owners of properties in India are obligated to fulfill their legal duty of paying capital gains tax when they decide to sell their property. The concept behind this tax is that the sale of a property usually results in the owner making a profit.

What exactly is a capital gain?

A capital gain refers to the increase in the value of an asset over a specified period of time. This gain is realized by the owner when they proceed to sell the asset. Essentially, a capital gain represents the difference between the selling price and the price at which the asset was initially purchased.

Also worth noting: TDS on the sale of residential property in accordance with Section 194IA

The determining factors for capital gains tax on property sales:

Several factors come into play when calculating capital gains tax on property sales:

The cost of the property

The cost of the property includes the money spent on acquiring it (which covers brokerage charges, stamp duty, and registration fees), as well as any expenses related to its improvement and renovation. For instance, if a property was purchased for Rs 50 lakh and an additional Rs 20 lakh was spent on renovation, the total cost for tax calculation purposes would amount to Rs 70 lakh.

Cash payments made for property improvement

The Mumbai Bench of the Income Tax Appellate Tribunal (ITAT) has ruled that property sellers who choose to pay cash for home improvement can factor this amount into the computation of their overall property cost when determining their capital gains tax liability.

Recently, a petitioner named Komal Gurumukh Sangtani appealed to the ITAT after the assessing officer denied a deduction for the cost of property improvement during the capital gains tax assessment. In cases where cash payments have been made, the taxpayer must provide evidence that no unaccounted money was utilized for payment. Additionally, the source of the cash payments made for improvement works must be explained to qualify for tax relief.

Holding period before capital gains

Under current Indian tax laws, the duration of property ownership before its sale, commonly referred to as the holding period, is a crucial factor in determining the tax liability. If the transaction is classified as a short-term capital gain (STCG), the tax liability will be higher. On the other hand, transactions falling under the category of long-term capital gains (LTCG) will be taxed at a rate of 20.8% of the profit, regardless of the individual's tax bracket.

Another important aspect to consider is that in the case of LTCG, tax payers are eligible for multiple rebates under the provisions of the IT Act. However, when it comes to STCG, opportunities to reduce the tax liability are extremely limited. Tax payers can only offset the gain against any short-term losses from the sale of assets such as stocks and gold, among others.

Additional information: Everything you need to know about indexation benefit

Investing in a new property

If you decide to reinvest the proceeds from the sale of your old property into a new one within a specific timeframe and subject to certain conditions, your tax liability will be significantly reduced and may even amount to zero.

Latest update:  As per a circular issued on January 6, 2023, by the Central Board of Direct Taxes (CBDT), the deadline for making these investments has been extended. According to the notification, investments that were supposed to be made between April 1, 2021, and February 28, 2022, must now be completed by March 31, 2023.

Ownership of Property

When an individual has multiple properties, the tax liability for selling those properties is always higher compared to someone who owns only one property. Later in this article, we will delve into the specific provisions that establish this fact.

See also: Tax Exemption on Long-Term Capital Gains for Multiple Home Purchases

Strategies to Save Capital Gains Tax on Property Sale

We will now explore the various options available for sellers to minimize their capital gains tax when selling a property.

Section 54: Purchasing a New Property

If you sell a property within two years of purchasing it, the profit from the sale will be considered Short-Term Capital Gains (STCG) and taxed based on your applicable tax slab.

The deductions provided by Section 54 only apply when you sell a property after holding it for more than two years, resulting in Long-Term Capital Gains (LTCG). In such cases, while the profits are taxed at 20.8% with indexation benefits, Section 54 offers certain relaxations if specific conditions are met. These conditions include:

Number of Properties for Capital Gains Exemption

You can invest the capital gains from the property sale in purchasing or constructing up to two houses. It is essential to note that before the 2019 Budget, this exemption only applied to one property. If you choose to reinvest in two properties, the deduction is only available if the capital gains from the property sale do not exceed Rs 2 crores. Additionally, this benefit can only be claimed once in a lifetime.

Holding Period to Claim Capital Gains Tax Exemption on Property Sale

The law imposes certain restrictions regarding the timing, location, and holding period of the new property. Firstly, the new property must be purchased one year before the sale or two years after the sale of the primary property. If you choose to construct a house, it should be completed within three years of selling the property. Secondly, the new property must be situated in India.

If the new property is sold within three years of purchase, the relaxation in tax will be reversed, and the profit earned from this sale will be treated as short-term capital gains.

To claim the exemption on the entire LTCG amount, the entire profit must be reinvested in the new property. If not, the exemption will be limited to the amount reinvested. For example, if you earn a profit of Rs 20 lakhs from the sale and reinvest only Rs 15 lakhs in a new property, the remaining Rs 5 lakhs will be subject to taxation. You can increase the deduction limit by including all associated charges such as stamp duty, registration fees, and brokerage fees in the cost of the new house. Similarly, expenses incurred for repairs and renovations can be added to the overall purchase cost when calculating LTCG.

The capital gains tax exemption under Section 54 is applicable if you have taken a home loan to buy the new property or to repay the home loan for the old property.

Benefits of Indexation on Capital Gains Tax for Property Sale

Indexation refers to the adjustment of the property's purchase price for inflation. This benefit allows the seller to account for the impact of inflation on the historical acquisition cost, thereby reducing the amount on which capital gains tax is calculated. Without this benefit, the tax would be based on a much higher amount.

For further information, please refer to: Indexation: Understanding its impact on calculations for long-term capital gains tax

When calculating the Long-Term Capital Gains (LTCG) tax, you deduct the indexed cost of the property from the net sale price. It is important to note that you can take advantage of the benefits of indexation for long-term capital gains. To illustrate this, let's consider a scenario where you purchased a property in 1994-95 for Rs 20 lakhs and sold it in 2015-16 for Rs 1 crore. In this case, your long-term capital gains would not amount to Rs 80 lakhs. Instead, the calculation would be 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).

The index stood at 259 in 1994-95 and 1,081 in 2015-16.

Therefore, the indexed cost of acquisition would be = 20 x (1081/259) = 83.48

Your long-term capital gains would amount to = 100 – 83.48 = 16.52 lakhs.

Eligible Bonds for Exemptions under Section 54 EC

To claim deductions, sellers do not necessarily have to reinvest the sales proceeds into real estate. They can also reinvest the money in specific bonds.

As per Section 54EC, proceeds from the sale of land and buildings will be exempted from LTCG tax if the profits are reinvested in specified bonds within six months of the sale. Notable bonds specified in Section 54EC include those issued by the Railway Finance Corporation, the National Highways Authority of India, and the Rural Electrification Corporation, among others. It is important to note that this investment has a lock-in period of five years and is capped at Rs 50 lakhs.

Furthermore, it is worth mentioning that this exemption is applicable for both residential and non-residential properties. The interest earned on these bonds, which is 5.25% annually, is subject to full taxation. However, the maturity proceeds of the bonds are completely tax-free.

For more information, refer to: Understanding the share of a wife in her husband's property after his demise

Exemptions under Section 54GB

If you sell a house or plot and the profit is classified as LTCG, you can qualify for an exemption under Section 54GB by investing the proceeds in the subscription of equity shares of eligible companies. This exemption is applicable when the profit is reinvested in small or medium enterprises or eligible start-ups. For instance, if you are using the sales proceeds of a house property to buy computers and other equipment for your start-up, you can claim deductions under this section.

In any case, the minimum holding period for the new asset should be five years. This exemption under Section 54GB is available only to individuals or Hindu Undivided Families (HUFs). To claim the benefit, the taxpayer must use the net consideration before the due date for filing the income tax return.

Offsetting Capital Gains with Losses

Property sellers have an additional option to reduce their tax liability on property sales by offsetting the LTCG from the sale of the house against any long-term losses from the sale of other assets, such as stocks and gold. This can include losses carried forward from the past eight years, as well as losses incurred in the year in which you are claiming the benefit.

Factors to Consider for Capital Gains Tax on Property Sale

• If you have invested in a housing project that is experiencing delays and the developer has been unable to provide possession, you are still eligible to claim exemptions under various sections of the tax law.
• Depending on the duration of ownership, the profit from the transaction will be categorized as either Short-Term Capital Gain (STCG) or Long-Term Capital Gain (LTCG) and taxed accordingly. Additionally, the benefits provided under Section 54 and Section 54EC will be applicable.
• According to state government authorities, a property cannot be registered below a specified value. Even if you agree to sell the property for a lower price, the registration will still be done at the minimum allowed value in that area. The entire tax liability will be calculated based on the property's value as determined by the sub-registrar's office.
• If you are unable to invest the sales proceeds into purchasing another property or reinvesting the funds into specified bonds, the remaining amount should be deposited in the Capital Gains Account Scheme. This will allow you to claim deductions.

Related: Everything you need to know about ancestral property

What to avoid when selling a property

• To protect your interests, it is crucial to report the transaction to the tax authorities and fulfill all payment obligations within the specified timeframe. Avoid getting entangled in legal obstacles later.
• In certain cases, the buyer may insist on making a portion of the payment through unrecorded channels. Although this might help you save on taxes, it will also decrease the registered value of your property. In the future, selling the property may result in a loss.

Related: Everything you need to know about sale deed and agreement to sale

Frequently Asked Questions

How can I avoid paying short-term capital gains tax on property sale?

One can avoid paying STCG tax if the sale occurs more than 24 months after purchasing the property in question.

What is the tax rate for short-term capital gains on property sales?

The tax rate for STCG on property sales is based on the seller's applicable tax bracket.

What is the tax rate for long-term capital gains on property sales?

In India, the seller is required to pay a 20.80% LTCG tax on the profit portion of the sale.