This is part of a new series on taxation for investors in India by Sandeep Koonaparaju. Sandeep is a practicing Chartered Accountant based out of Bangalore. His area of expertise and interest is Taxation. He can be reached at sandeep.vvc98 [at] gmail.com.
The Concept of Capital Gains Taxation
The Income Tax Act requires your income to be classified into one of these buckets to determine the tax payable
- Salary
- House property
- Business income
- Income from other sources
- Capital Gains
With the increase in investing and trading in securities over the past few decades, capital gains have become an important source of income for many taxpayers. In this article, we’ll explore how capital gains are taxed and get into the weeds around offsetting gains and losses.
Let’s start with the basics!
What is a Capital Asset?
- What is a capital gain or loss? In simple terms, any gain or loss arising from the transfer of a ‘capital asset ‘.
- What is a capital asset? It is defined as property of any kind held by a taxpayer. Personal effects are, however, excluded from the definition, with few exceptions.
- What are personal effects and what are the exceptions? Personal effects are movable property held for personal use by the taxpayer. All personal effects are not excluded from the definition of capital asset. Property such as Jewelry, drawings, paintings, art of work etc. are considered as capital assets. This implies that if you sell your personal jewelry or painting held in your house, any gain arising from the transaction will be taxed as capital gain.
- Should I pay capital gains tax if I sell my personal car for profit? Your car is a personal effect, not covered by the exception. So it’s not a capital asset and is not taxed (we find this surprising too but rules are rules).
Capital Gain/Loss
- What are the types of capital gains and losses? Capital gains and losses can be either Short Term or Long Term.
- What is the basis for classifying Gain/Loss into short term or long term? The period of holding and the type of capital asset sold.
The Classification of different types of capital assets based on their period of holding is explained in the table below:
- What are the rules related to shares in foreign companies? Shares in foreign companies are considered as long term if they are held for more than 24 months, however, if the foreign shares are listed in a stock exchange in India i.e. a stock exchange located in IFSC, then the time period is 12 months.
- Note that the same rule applies to unlisted Indian companies – 24 months holding term makes the holding long-term.
- Why is it important to classify gains and losses into long term or short term? – There are three key differences between long term and short term, that will impact your tax outflow:
- The rates of taxation
- Rules related to set off and carry forward of losses
- Re-investment options to defer/mitigate the tax impact (certain options are available only for long term gains)
Let’s look into these differences in detail.
Set Off and Carry Forward of Capital Losses:
While the definition of the word ‘income’ under the Act does not specifically call it out, it is an established legal principle that for computing the taxable income of a person, losses cannot be ignored. The law allows a taxpayer (subject to few restrictions) to offset losses from one source of income against gains from other sources.
While the topic of set off and carry forward of losses is dealt with in a separate article, let us understand the rules pertaining to set off and carry forward of capital losses and the related restrictions here.
Restrictions pertaining to intra-head adjustment (i.e. offsetting of capital losses from one source against capital gains from another source)
- Long term losses can be offset only against long term gains. – There is, however, no restriction on offsetting short term losses against long term gains.
Restrictions pertaining to inter-head adjustment (i.e. offsetting of capital losses against income from other heads)
- Where net result under the head ‘capital gains’ is a loss, such loss cannot be offset against any other head of income.
- Such loss should be separated into short term and long term capital loss and can be carried forward for 8 years.
Both the restrictions discussed above apply for the losses so carried forward.
Here are one example over 2 years that illustrates the impact of the two restrictions discussed above:
Year 1:
Mr. X has
Short term capital gain of INR 50,000
Long term capital loss of INR 75,000 and
Profit from business amounting to INR 6,00,000.
His total income for the year is:
Long term capital loss can be carried forward for 8 years. It cannot be offset against short term capital gain (under the first restriction) or business income (under second restriction).
Year 2:
Mr. X has
Long term capital gain of INR 3,00,000
Short term capital loss of INR 2,50,000 and
Business Income amounting to INR 5,00,000.
His total income for the year is:
The remaining short term capital loss of INR 25,000 cannot be offset against business income pursuant to the second restriction above. You carry that forward to the next year.
Offsetting of losses from other heads of income, against capital gains:
So far, we discussed different scenarios with losses under the head ‘capital gains’ and the related restrictions on the set off. The question that invariably pops up now is can losses under other heads of income be offset against capital gains?
The answer is fortunately – Yes. There are no specific restrictions on offsetting losses from other heads of income against capital gains. There are however few general restrictions, such as losses from speculative business not permitted to be offset against any other income, restricting the loss from house property to INR 2,00,000 etc. These general restrictions are applicable to every head of income including capital gains.
Let’s understand this with an example:
Mr. X made a loss of INR 50,000 from speculative business and loss of INR 4,00,000 from non speculative business. He also has a loss of INR 2,50,000 under the head ‘Income from house property’, and a long term capital gain of INR 7,00,000.
His total income for the year would be:
*House property loss in excess of INR 2,00,000 cannot be offset against any other head of income. The taxpayer is however, permitted to carry forward the excess loss of INR 50,000 to subsequent years.
Loss from speculation business can be set off only against profits from speculative business.
Please refer to our separate article on set off and carry forward of losses for more details.
Re investment options to defer/mitigate tax impact on capital gains.
A taxpayer has multiple tax planning options under law to defer or mitigate the tax impact on capital gains. These options vary depending on the type of asset sold, type of gain (long term or short term) amount invested and the time limit for such investment. In this article we covered a few such scenarios.
Scenario I – Type of asset sold – Long Term Residential House Property.
Who can claim the exemption? – Individual/HUF
Where to invest? – One residential house.
Time limit for investment? – Purchased 1 year before or two years after the date of transfer or constructed within 3 years from the date of transfer.
What to invest – Capital Gain or Sale Proceeds? – Capital Gain. If the cost of the new house is less than the amount of gain, then gain to the extent of such cost will be exempted from tax and the balance will be taxed. If the cost of the new house is more than the gain, entire gain is exempted from tax.
Lock in period for new house? – If the new house is sold within 3 years from the date of purchase or construction, capital gain exempted earlier will be taxed in the year of sale of the new house.
What if I couldn’t invest in the new house before filing the return of income? – You may deposit the money in a bank account pursuant to the rules framed under ‘Capital Gain Account Scheme’. Gain, to the extent of money deposited in such an account will be exempt from tax. The deposit should be made before the due date for filing return of income.
How long can I hold the money in such account without attracting tax? – If the money deposited is not utilized for investment in the new house, the un-utilized amount will be taxed upon completion of 3 years from the date of transfer of original house.
If the cost of one house does not cover the entire gain, can I invest in multiple houses? – Subject to the following conditions:
- Amount of gain does not exceed 2 crore rupees
- It’s a one time option given to taxpayers. It can be availed only in any one financial year. Once availed, this option cannot be availed in subsequent years.
Scenario 2 – Type of asset sold – Land Used for Agricultural Purposes.
Who can claim the exemption? – Individual/HUF
What is agricultural land? – Land, which, in the immediately preceding two years has been used for agricultural purposes either by the individual or his parent (where tax payer is an individual) or by the HUF (where taxpayer is a HUF).
Where to invest? – Any other agricultural land.
Time limit for investment? – 2 Years from the date of sale.
What to invest – Capital Gain or Sale Proceeds? – Capital Gain. If the cost of the new land is less than the amount of gain, then gain to the extent of such cost will be exempted from tax and the balance will be taxed.
If the cost of the new land is more than the gain, the entire gain is exempted from tax.
Lock in period for new land? – If the new land is sold within 3 years from the date of purchase capital gain exempted earlier will be taxed in the year of sale of the new land.
What if I could not invest in the new land before filing the return of income? – You may deposit the money in a bank account pursuant to the rules framed under ‘Capital Gain Account Scheme’. Gain, to the extent of money deposited in such an account will be exempt from tax. The deposit should be made before the due date for filing return of income.
How long can I hold the money in such account without attracting tax? – If the money deposited is not utilized for investment in the new land, the un-utilized amount will be taxed upon completion of 2 years from the date of transfer of original land.
Scenario 3 – Type of asset sold – Long Term Capital Asset Being Land or Building or both.
Who can claim the exemption? – Any taxpayer
Where to invest? – In the following bonds (known as 54EC Bonds in common parlance)
- Bonds issued by National Highway Authority of India on or after 1-4-2018, redeemable after 5 years.
- Bonds issued by Rural Electrification Corporation Limited (RECL) on or after 1-4-2018, redeemable after 5 years.
- Any other bonds notified by Central Government*
*Bonds issued by Power Finance Corporation Limited (PFCL) and Indian Railways Finance Corporation Limited (IRFCL) have been notified.
Time limit for investment? – 6 months from the date of sale.
What to invest – Capital Gain or Sale Proceeds? Is there any limit on the amount that can be invested? – Capital Gain. If the amount invested is less than the amount of gain, then gain to the extent invested will be exempted from tax and the balance will be taxed.
If the amount invested is more than the gain, entire gain is exempted from tax.
The maximum amount that can be invested with respect to one sale transaction is INR 50 Lacs.
If the capital gain is INR 1 crore, a taxpayer can invest only 50 Lacs in 54EC bonds. Remaining gain will be taxed, unless invested in other options such as residential house or agricultural land etc. depending on the type of asset sold.
Lock in period for the bonds – If the bonds are sold or converted within 5 years from the date of purchase, capital gain exempted earlier will be taxed in the year of such sale or conversion.
Scenario 4 – Type of asset sold – Any Long Term Capital Asset not being a Residential House.
Who can claim the exemption? – Individual/HUF
Where to invest? – One residential house in India.
Time limit for investment? – Purchased 1 year before or two years after the date of transfer or constructed within 3 years from the date of transfer.
What to invest – Capital Gain or Sale Proceeds? – Sale Proceeds. If the cost of the new house is less than the sale proceeds, a proportionate share of the gain will be taxed.
If the cost of the new house is more than the sale proceeds, the entire gain is exempted from tax.
Lock in period for new house? – If the new house is sold within 3 years from the date of purchase or construction, capital gain exempted earlier will be taxed in the year of sale of the new house.
What if I couldn’t invest in the new house before filing the return of income? – You may deposit the sale proceeds in a bank account pursuant to the rules framed under ‘Capital Gain Account Scheme’. The deposit should be made before the due date for filing return of income.
How long can I hold the money in such an account without attracting tax? – If the money deposited is not utilized or partly utilized for investment in the new house, a proportionate amount of capital gain will be taxed upon completion of 3 years from the date of transfer of original house.
Additional conditions, if any? – Exemption cannot be claimed if the taxpayer:
- Owns more than one residential house, other than the new house, on the date of transfer of original asset. Or
- Purchases any residential house, other than the new house, within 1 year from the date of transfer of original asset. Or
- Constructs any residential house, other than the new house, within 3 years from the date of transfer of original asset.
Scenario 5 – Type of asset sold – Any Long Term Capital Asset being a Residential Property.
Who can claim the exemption? – Individual/HUF
Where to invest? – Subscribe to equity shares of an ‘’eligible company’’.
What’s the time limit for subscribing to such shares? – Before the due date for filing ITR for the individual/HUF.
What’s an eligible company? – Company incorporated on or after 1st April but before the due date for filing ITR of the year in which the residential property was sold.
- Engaged in the business of manufacture of an article or thing, or other ‘eligible business’.
- The individual/HUF holds more than 25 percent of share capital/voting rights after the subscription.
- The company qualifies to be a small/medium enterprise under MSME Act or is an ‘eligible start up’.
Any restrictions on how should the company utilize such money? – The company should within 1 year from the date of subscription to shares utilize such money for purchase of ‘new asset’.
What to invest – Capital Gain or Sale Proceeds? – Sale Proceeds. If the cost of the new asset is less than the sale proceeds, a proportionate share of the gain will be taxed.
If the cost of the new asset is more than the sale proceeds, the entire gain is exempted from tax.
Lock in period for new asset/shares? – If either the company or the Individual/HUF transfers the new asset or the equity shares within a period of Five Years from the dates of their acquisition respectively, the amount of gain exempted earlier will be taxed in the year of such transfer.
What if the company couldn’t invest in the new asset before due date for filing ITR? –The company may deposit the amount received from issue of shares in a bank account pursuant to the rules framed under ‘Capital Gain Account Scheme’. The deposit should be made before the due date for filing ITR.
How long can the company hold the money in such an account without attracting tax? – If the money deposited is not utilized or partly utilized for investment in the new asset, a proportionate amount of capital gain will be taxed upon completion of 1 year from the date of subscription of shares.
Note: The terms ‘eligible business’ and ‘eligible start up’ have been defined in 80 IAC of the income tax Act and have not been dealt with in this article
The subject of capital gains taxation is very vast and we’ve just covered the basics of tax rates and offsetting gains and losses in this article. We’ll be tackling the tax implications of gifting in our next article.
If you’re a Capitalmind Premium member you can continue the conversation and ask more specific questions on the #taxation channel in Slack.
You can also reach me on my email sandeep.vvc98 [at] gmail.com
