Capital Gains Tax on Real Estate

Capital Gains Tax on Real Estate

To get a better and deeper understanding of how capital gains tax is related to real estate, its role, and how to save capital gains tax on real estate, we first need to have a basic understanding of what capital gains tax is. 

What are capital assets, and What is Capital Gains Tax?

Before digging up the mountain of capital gain tax, we need to know what capital assets are. 

Capital assets are noteworthy pieces of property that are useful in generating revenue for a company over more than a year. 

For example, when a company buys a computer for official usage, then the computer is a capital asset. 

In more simple words, longer assets that can generate cash flows in the future, e.g., land, building, shares, property, mutual funds, gold, patents, trademarks, leasehold rights, etc. 

Property (i.e., residential property, commercial property, or plot) or real estate is a primary component of a capital asset (except rural agricultural land).

The capital gain can be said to be any profit received through the sale of a capital asset; the profit earned comes under the income category. 

Hence, a tax must be paid on the income (including the profit) received, which is known as capital gains tax. 

This tax can be categorized further as – long-term capital gain tax (LTCG) (i.e., gains on capital assets held for more than 24 months) and short-term capital gain tax (STCG) (i.e., gains on capital assets held for less than 24 months) and have different proportions levied, respectively. 

The difference between these two taxes is important as both of these are treated differently in terms of taxation, i.e., while calculating tax.  

Calculation of Capital Gains Tax on Real Estate

From the definition above, we can chalk out what capital gains tax is, and this being said, it also infers that capital gains tax also has a relation with real estate (i.e., the tax paid on the profits (capital) gained (gains) upon the selling of property) as it falls under the category of a capital asset. 

Hence, we also need to know how this tax is calculated. The calculation of this tax is also based on the type of tax it is, i.e., whether it is a long-term capital gains tax or a short-term capital gains tax. 

In simple terms, the calculation of this tax is dependent on the type of capital gain. 

Before delving into the methodology of calculation of capital gains tax, we need to be familiar with the following variables which are required for the calculation of this tax, 

usually done with the help of various online tax calculators available – purchase price, sale price, details regarding the purchase (i.e., date, month, year of purchase), details regarding the sale (i.e., date, month, year of sale) and investment details (i.e., the investment done on the capital gain in the form of debt funds, shares, equity funds, real estates, etc.).

So how does one calculate the capital gains tax?

The short-term capital gain tax on real estate is much simpler than the long-term capital gain tax. 

The gain is added to the total income for the short-term gain, and then the Income Tax is calculated based on the tax bracket one falls in. 

The formula for short-term capital gain tax (STCG) on real estate is as follows:

  • Short-term capital gain = full value consideration – (cost of acquisition + cost of improvement + cost of transfer)

The calculation of long-term capital gain tax on real estate is convoluted. In the case of long-term capital gain tax, inflation is added while computing the tax since one gets to hold the assets for a longer period (i.e., more than 36 months). 

The formula for calculating the long-term capital tax (LTCG) is as follows:

  • Long-term capital gain tax = full value of the consideration received – (indexed cost of acquisition + indexed cost of improvement + cost of transfer)

Here:

  • The indexed cost of acquisition is the cost of acquisition x cost of inflation index of the year of transfer/cost inflation index of the year of acquisition. 
  • The indexed cost of the improvement is the cost of improvement x cost inflation index of the year of transfer/cost inflation index of the year of improvement.

How will you save Capital Gains Tax?

Taxation is generally treated and looked up to as a burden by the common masses, and they tend to find ways to exempt themselves from paying taxes. 

In the aspect of real estate too, there are three ways how one can save on long-term capital gain (LTCG) tax concerning residential property and other types of properties as well.  

In the first instance, if we consider residential property, we will see that this provision is covered under Section 54 of the Income Tax Act. 

  • Under Section 54, the benefit can be claimed by an individual or an undivided Hindu family who owns the residential property and further buys some other residential property. 
  • This clause of Section 54 applies only to residential house property; no other type of property is covered. Here, residential house property refers to the sale of constructed houses on that property and does not cover the sale of residential plots. 
  • There should be a minimum holding period of 24 months. 
  • The assets to be acquired under this clause include up to two residential house properties, where one can get an exemption from capital gains tax (updated in the Budget 2019). 
  • One cannot get an exemption if the person buys a residential plot instead of a residential house property. One can use the number of capital gains to construct or purchase residential house property. 

Besides these, there are some other important conditions related to this Section 54 of the Income Tax Act. 

Firstly, one has to invest only the capital gains amount, i.e., the amount gained or profit earned (even though one can invest more than that) but will only get tax exemption on the amount of capital gained or profit earned. 

For example, if one has bought a property for 20 lakhs 5 years ago and sells that same property for 45 lakhs on the present date, then he/she will get tax exemption only on the amount gained or profit, i.e., 25 lakhs only. 

Secondly, the maximum claim on capital gains can be up to 2 crores, on which one can claim tax exemption and can be claimed only once in a lifetime under Section 54. 

The exemption of tax will be reversed if the new property bought is sold within 3 years of its purchase and will be added to the income of that particular year in which the property is sold. 

Finally, one has to invest the capital gain in Capital Gain Account Scheme.

In the second instance, if we consider any property or other capital asset, we see that it is covered under Section 54EC of the Income Tax Act. 

  • Under this Section, the benefit can be claimed by any individual. 
  • This section includes eligible capital assets such as Stocks, Bonds, Mutual Funds, House Property, Commercial Property, Plot, etc. 
  • The minimum holding period, in this case, should be 3 years.
  • Under this clause, one has to invest in specified binds, which have a minimum lock-in period of 5 years, usual bonds of the National Highways Authority of India (NHAI) and Rural Electrification Corporation (REC). If one invests in such specific bonds, can one get a tax exemption under Section-54EC of the Income Tax Act? 
  • One has to invest in NHAI or REC within 6 months of selling any capital asset. 
  • The maximum tax exemption that one can get is up to 50 lakhs and includes only the capital gains amount. 
  • Under this clause, one need not open a Capital Gains Account as in Section-54, but the returns available are low, i.e., only 5.5%-6% on these specific bonds. 

The third way how one can save on long-term capital gain (LTCG) tax is covered under Section 54F of the Income Tax Act. 

  • Under this Section, tax exemption can be claimed by any individual or undivided Hindu family. 
  • The assets eligible under this Section covers any capital asset other than house property, such as stocks, bonds, mutual funds, commercial property, plot, etc. 
  • One individual cannot hold more than 1 residential house property, and only then does one become eligible for tax exemption under Section 54F. To benefit from tax exemption, one must acquire only residential house property (not on residential plots) by purchasing or constructing one.

Besides these, there are some other important conditions of Section 54F under the Income Tax Act. 

Firstly, one has to invest the entire sale proceeds and not just the capital gain. 

For example, if one bought a property for 20 lakhs 5 years ago and now sells the property for 45 lakhs, then he has to invest the total income of 45 lakhs and not just the capital gain, which is 25 lakhs (profit). 

If one invests only the capital gain, one will not be entitled to the entire tax exemption but only the equal exemption of the capital gained. 

If the new property is sold within 3 years of purchase, the tax exemption will be reversed and added to the individual's income tax. 

Under this clause, one has to keep the total amount under the Capital Gains Account Scheme to avail of tax exemption under Section 54F. 

The clauses of Section 54F are similar to that of Section 54. The only difference is that under Section 54F, the entire sale proceeds have to be invested, unlike that of Section 54, where only the capital gain has to be invested. 

Capital gains tax on real estate as a duty

Any residential property bought by us, be it a house, flat, or plot, is ultimately ours, and we can claim it as "our home". 

To legally safeguard our claim, we must pay capital gains tax on real estate or our property. 

Through this, we can become responsible citizens of a society marked by progress and development. 

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Conclusion

This particular blog throws light on capital gains tax and how it is related to real estate, enlightening us on the basic notions of what a capital asset is and how it shares an intrinsic relation with capital gains tax. 

It also makes the readers well aware of the types of capital gains tax, i.e., long-term capital gains tax (LTCG) and short-term capital gains tax (STCG). 

This blog also deals with the method of calculating the two kinds of taxes and the various ways one can resort to exempt capital gain tax. 

And most importantly, it upholds the fact that we need to pay capital gains tax as dutiful citizens of our society.  

FAQs related to Capital Gain tax on real Estate

1. Does one need to pay capital gains tax on inherited property?

Even if one sells a property that was inherited from one’s ancestors or might be gifted by someone, one still has to pay capital gains tax on it. And in such a case, the cost of purchase is calculated on the cost to the previous owner. 

2. How can you calculate capital gains tax on real estate? 

In the case of short-term capital gain, the formula is:

Short-term capital gain = final sale price – (cost of acquisition + cost of improvement + cost of transfer)

In the case of long-term capital gain, the formula is:

Long-term capital gain = final sale price – (indexed cost of acquisition + indexed cost of improvement + cost of transfer)

3. Should we pay capital gains tax?

We must pay capital gains tax, even though there are ways of tax exemption under the Income Tax Act. 

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