A few years ago, Aarav inherited a parcel of land from his parents. Since he lives in the city and has no plans of going back to his hometown, he decides to sell the land. He then uses the money to buy an apartment right in the heart of the city. It took almost three years for Aarav to buy the apartment after selling his inherited property. He falsely assumes that there is no tax liability in his reinvestment. After some time, he finds out from a tax consultant or worse, from the tax authorities, that he will have to pay tax on the capital gained from the sale of his inherited property.
It may have occurred to Aarav that the property he received is not subject to tax. This is true. In India, any asset that is received as an inheritance is fully exempt from gift tax. So he’s not obligated to pay any tax upon receipt of the parcel of land from his folks.
But the sale of the asset is not exempted from tax. This is taxable under capital gains.
In India, it is not uncommon for taxpaying individuals like Aarav to inherit properties such as land or house from their families. And just like what Aarav did, these individuals would sell the property and invest in another property at some point in time.
However, it is also common for many people in India to be unaware of tax laws regarding inherited properties like land and house, as well as the tax stemming from the sale of those properties. They would only know of the tax liabilities they have when notified by the tax authorities, or as in the case of Aarav, when informed by his tax consultant or a chartered accountant.
It is thus very important for individual taxpayers in India to know of these laws especially if they are to inherit a property from their families.
What is Capital Gains?
In the case of Aarav, he failed to realize that he had to pay the capital gains tax from the sale of the parcel of land that he disposed of. By definition, capital gains is the profit that Aarav got when he sold the capital asset (in his case, the parcel of land) for a price higher that the purchase price.
Capital assets are property held in any kind by the taxpayer. It may be a parcel of land, a building, a house, or a vehicle. Leasehold rights, trademarks, patents and even jewellery may be considered as capital assets as well. In certain cases, capital assets may include rights of management to any Indian company.
Thus, capital gains tax not only applies to the sale of an inherited house or parcel of land. It can also apply to the sale of a vehicle, patent, and jewellery.
Capital assets are classified into two – short-term capital asset and long term capital asset.
In Aarav’s case, the sale of the inherited land took him 35 months after the date of the transfer into his name. As such, it is considered short-term capital asset.
If he had disposed the property a month or so longer, it would have been treated as long-term capital asset.
Under the Indian tax laws, the following aren’t considered capital assets:
- Stock in trade
- Consumable stores or raw materials
- Personal effects
- 5 percent gold bonds
- Gold deposit bonds
- Special Bearer Bonds 1991
- Agricultural land in a rural area. As of AY 2014-15, rural area is defined as any area outside the jurisdiction of a municipality having a population of 10,000 or more.
Calculating Capital Gains
Short-term capital gains and long-term capital gains are computed differently.
Long term capital gain is computed as the full value of consideration fewer expenditures incurred wholly in connection with the transfer of the capital asset. This includes brokerage, commission, and advertisement expenses, among others. Indexed cost of acquisition and indexed cost of the improvement, if any, may also be deducted.
Full value consideration pertains to the amount that the seller agrees to get in exchange for his or her capital assets. It should be noted that capital gains is chargeable to tax in the year of the transfer.
t of acquisition pertains to the amount for which the capital asset was acquired by the seller. Cost of improvement, on the other hand, pertains to the expenses incurred to make improvements to the capital asset. However, all, improvements made before April 1, 1981 won’t be taken into consideration.
On the other hand, short term capital gains is computed as the sales value of the asset less expenses incurred related to the transfer of the capital asset. Cost of acquisition, or the purchase price of the capital asset, as well as cost of improvement, may also be deducted from the sales value of the asset.
Cost of acquisition pertains to the amount that any of the previous owners has paid to acquire for the property. Going back to Aarav’s case, let’s say that his grandfather was the original owner of the parcel of land. He had purchased it for Rs 20,000. This will be the cost of acquisition that Aarav can deduct to arrive at the short-term capital gains tax.
It can be said that calculation of long term and short term capital gains is basically the same. The only difference is that in calculating long-term capital gains, the cost of acquisition and improvement is indexed, or adjusted for inflation.
Short term capital gains on the sale of a property are taxable per slabs rates as applicable to the individual taxpayer. This means that the capital gains tax is payable at the same rate as the income tax of the tax payer. In Aarav’s case, the capital gains would have been taxed at a rate of 25 per cent if he falls under the 25 per cent bracket.
On the other hand, long-term capital gains are taxable at a uniform rate of 20% plus surcharge and education cess.
Exemptions Under Income Tax Act
However there are exemptions on capital gains that can be applied as specified under certain sections of the Income Tax Act of 1961.
Going back to Aarav’s case, if he had used the proceeds arising from the sale of his inherited property, then he could have been exempt from paying capital gains tax.
Section 54, for instance, exempts sale of house property on the purchase of another house property. In this case, the capital gains arising from the sale of a house property is used in buying another house property.
The new property should have been purchased a year before the sale of the inherited property or two years after the sale of the property.
Going back to Aarav’s case, if he had bought the property he now has in the city within two years after he sold his inherited land, then he would have been able to apply for this exemption. Or, if he had bought the house a year before he was able to dispose of the parcel of land he inherited from his family.
Also, he could have been exempt from capital gains if he used the gains in the construction of the property that was completed within three years from the date of the sale of the inherited property.
It should be noted that under this section, only one house property can be bought or constructed using the capital gains to claim the exemption. The exemption can be nullified if the new property is sold within three years of its purchase or construction.
Investing in Bonds
Under Section 54EC, exemption is available when the capital gains from the sale of the first property are reinvested into specific bonds. These bonds are issued by the Rural Electrification Corporation and the National Highway Authority of India. Investment in these bonds should be up to Rs.50 lakhs.
The money that Aarav invested in bonds should be redeemed after three years. However it cannot be sold before the lapse of three years from the date of sale. Aarav should have invested the money he gained from the sale of his inherited land within six months after the sale of the property to have been able to claim this exemption.
The tax exemption is equal to the capital gain or to the investment, whichever is lower. Transferring the bonds or taking a loan against them within three years is forbidden, though. It can result to the capital gain becoming taxable.
Investing in these bonds would yield a return of 5.5 per cent interest in a year.
Capital Gains Account
Aarav could have also invested the money that he had gained from the sale of his inherited property in a Capital Gains Account. This is specified under the Capital Gains Account Scheme. Aarav could have deposited the money in any public sector bank. The deposit can then be claimed by Aarav as exempted from capital gains. Moreover, he won’t have to pay any tax on it.
However, Aarav should have done this before the deadline for filing tax returns which usually is on July 1. The money deposited in the account should only be used in buying or constructing a residential house within the prescribed period.
There are two kinds of capital gains deposits in the market. One is a savings type account while the other is terms deposit. Any individual taxpayer can transfer money from one account to another by paying fixed penalties or charges in a bid to exempt his or her capital gains against tax.
In the savings deposit type of capital gains deposit, the money can be withdrawn as long as there is a declaration that the money will be for the construction or purchase of a house. The money will have to be used for the declared purposes within 60 days. Any unutilized amount will have to be re-deposited into the capital gains account as well.
As far as interest rates are concerned, capital gains deposit will have the same rates as those on regular savings and term deposits. There’s also tax for the interest earned. Proof of deposit has to be attached with the taxpayer’s income tax return.
In the event that the deposited amount is not fully used to buy and construct a new house at the end of the three-year period from the sale of the asset, the money in the account will be treated as capital gains.
Opting to open a capital gains account should be considered only as a stop-gap measure. The individual taxpayer will eventually have to use the money to buy or build a house within a specified period.
There’s also an exemption specified under Section 54B of the 1961 Act. This specifies that short term or long term capital gains are tax exempt when the proceeds are used to purchase new agricultural land. The purchase should have been consummated within two years after the sale of the inherited property. Also, the agricultural land should not be sold within 3 years from the date of its acquisition.
Under Section 54G, exemption is also allowed if the gain is reinvested in acquiring a building or machinery in a rural area. There’s also exemption allowed if the gain is used in acquiring land, building, or machine in a Special Economic Zone as specified under Section 54GA.
The truth is that computing capital gains tax on the sale of a property, whether it is inherited or not, can be very tricky. It is thus highly recommended that tax payers who acquire a property and then sell it later on consult a tax expert or chartered accountant.
As shown in the case of Aarav, he would not have been caught surprised and unaware of his tax obligations had he consulted a tax expert or accountant before he sold his property and bought a new house. This only underscores the need to get professional advice especially when dealing with real estate.