Capital Gains Tax: A Step-By-Step Guide

Introduction

Capital gains are an essential aspect of personal finance, involving the profits earned from selling assets like stocks, real estate, or mutual funds. Understanding the definition and significance of capital gains and the associated tax implications is crucial.

What is Capital Gain?

Capital gain refers to an investor’s net profit by selling a capital asset at a price higher than its purchase cost. The entire value of selling a capital asset is taxable income. For taxation in a specific financial year, the transfer of the capital asset must occur in the previous fiscal year.

Financial gains from selling an asset do not apply to inherited property unless there is a change in ownership. The Income Tax Act exempts assets received as gifts or through inheritance from being included in an individual’s income calculation.

What are Capital Assets?

Capital assets include buildings, lands, houses, vehicles, Mutual Funds, and jewelry. The rights of management or legal rights over a company are also considered capital assets.

What are the types of Capital Assets?

The two types of Capital Assets are:

Short-Term Capital Assets (STCA): These assets are held for 36 months or less, except for immovable properties like land and buildings, where the criteria changed to 24 months from the fiscal year 2017-18. Selling a house property after holding it for 24 months qualifies any income generated as long-term capital gain if sold after March 31, 2017.

The reduced period does not affect movable assets like jewelry and debt-oriented mutual funds. Regardless of the purchase date, certain assets are considered short-term if held for 12 months or less, including equity/preference shares, securities, UTI units, equity-oriented mutual funds, and zero coupon bonds.

Long-Term Capital Assets (LTCA): These assets are held for more than 36 months or 24 months or more (from fiscal year 2017-18) for land, buildings, and house property. Equity/preference shares, securities, UTI units, equity-oriented mutual funds, and zero coupon bonds qualify as long-term capital assets for over 12 months.

How are Inherited Capital Assets Classified?

When an asset is obtained through gift, will, succession, or inheritance, the duration the previous owner held the asset determines whether it qualifies as a short-term or long-term capital asset. Additionally, for bonus or rights shares, the holding period is calculated from the date of allotment.

Tax Type	Condition	Applicable Tax
Tax on Long-Term Capital Gains	When selling equity shares or equity-oriented fund units	10% on amount exceeding ₹1,00,000
Tax on Long-Term Capital Gains	For other cases not involving equity-oriented fund units or equity shares	20%
Tax on Short-Term Capital Gains	In cases where Securities Transaction Tax (STT) is not levied	Added to your Income Tax Return (ITR) and taxed according to income tax slab rates
Tax on Short-Term Capital Gains	When Securities Transaction Tax (STT) is applicable	15%

What are the Exclusions from Capital Assets?

Items excluded from capital assets are:

• Stock, consumables, or raw materials held for business or professional purposes.
• Goods like clothes or furniture are used for personal purposes.
• Land for agricultural purposes in any rural part of India.
• Special bearer bonds were issued in 1991.
• Gold bonuses issued by the Central Government, such as the 6.5% gold bonus of 1977, the 7% gold bonus of 1980, and the defense gold bonus of 1980.
• Deposit certificates issued under the Gold Monetisation Scheme-2015 or gold deposit bonds issued under the gold deposit scheme-1999

What are the types of Capital Gains?

The two types of gains derived from investments, based on the duration of asset ownership, can be classified as follows:

1. Short-term Capital Gains: If an asset is sold within 36 months of acquisition, the resulting profits are referred to as short-term capital gains. For example, if a property is sold within 27 months of purchase, it falls into this category.
2. Long-term Capital Gains for Mutual Funds and Listed Shares: For Mutual Funds and listed shares, gains are considered long-term capital gains if the asset is sold after being held for at least 1 year.
3. Long-term Capital Gains for Immovable Properties: The profits from selling an asset held for more than 36 months are known as long-term capital gains. However, starting from March 31, 2017, the holding period for immovable properties was revised to 24 months. It’s important to note that this change does not apply to movable assets such as jewelry or debt-oriented Mutual Funds.

Key Terminology to Understand

To better understand capital gains, familiarize yourself with the following terms:

• Full Value Consideration: The total amount received or to be received by the seller for their capital assets, taxable in the year of transfer.
• Cost of Acquisition: The initial price at which the seller acquired the capital asset.
• Cost of Improvement: The expenses incurred by the seller to enhance the capital asset. Note that improvements made before April 1, 2001, are not considered.

How to Calculate Short-Term Capital Gains?

1. Begin with the full value of consideration.
2. Deduct the following:
   • Expenses exclusively incurred for the transfer.
   • Cost of acquisition.
   • Cost of improvement.
3. The resulting amount represents the short-term capital gain.

Short-term capital gain = Full value consideration – Expenses for the transfer – Cost of acquisition – Cost of improvement.

How to Calculate Long-Term Capital Gains?

1. Start with the full value of consideration.
2. Deduct the following:
   • Expenses exclusively incurred for the transfer.
   • Indexed cost of acquisition.
   • Indexed cost of improvement.
3. Deduct exemptions from the resulting amount under sections 54, 54EC, 54F, and 54B.

Long-term capital gain = Full value consideration – Expenses for the transfer – Indexed cost of acquisition – Indexed cost of improvement – Deductible expenses from the full value of consideration.

Note that deductible expenses directly relate to the sale or transfer of the capital asset and are necessary for the transfer to occur.

An exception exists for long-term capital gains on equity shares/units of equity-oriented funds. As per the Budget 2018, such gains realized after March 31, 2018, remain exempt up to ₹1 lakh per year. Gains exceeding ₹1 lakh in a single financial year will be subject to a 10% tax rate without indexation benefits.

Types of Deductible Expenses

1. Sale of House Property:
   • Stamp paper expenses
   • Commission or brokerage paid to secure a buyer
   • Travel expenses related to the transfer (incurred after the transfer is completed)
2. Sale of Shares:
   • Brokerage commission for the sold shares
   • Securities Transaction Tax (STT) is not deductible
3. Sale of Jewelry:
   • Brokerage expenses for the sale of jewelry, if a broker was involved in finding a buyer

Calculating Indexed Improvement/Acquisition Cost

The acquisition and improvement costs are indexed using the cost inflation index (CII) to account for inflation. This adjustment reduces your capital gains and increases your cost base.

The indexed acquisition cost is calculated as:

Indexed acquisition cost = (Acquisition cost * CII of the asset’s transfer year) / (CII of the financial year 2001-2002 or the year when the asset was first held by the seller, whichever is later)

For assets acquired before April 1, 2001, the acquisition cost should be the fair market value (FMV) or the actual cost on April 1, 2001, as per the taxpayer’s choice.

The indexed improvement cost is calculated as:

Indexed improvement cost = Improvement cost * CII of the year when the asset was transferred/improved

*Note that improvements made before April 1, 2001, should not be considered.

Equity and Debt Mutual Funds: Taxation

Gains on Selling Funds Effective July 11, 2014, Effective July 10, 2014, or prior

Debt Funds

• Short-Term Capital Gains (STCG): Taxed at individual’s slab rates of income tax
• Long-Term Capital Gains (LTCG): Taxed at 20% with indexation or 10% without indexation, whichever is lower

Equity Funds

• STCG: Taxed at 15%
• LTCG: Taxed at 10% for gains exceeding ₹1,00,000 without indexation

Debt Mutual Funds:

• Qualify for Long-Term Capital Gains if held for 36 months or more
• Gains are added to income if deducted within 36 months and are taxed based on the income tax slab rate.

Final Words

Understanding capital gains and tax implications is essential for effective financial management and optimizing tax planning strategies to make informed decisions and maximize investment returns.

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Read more:  How Long-term investing helps create life-changing wealth – TOI.