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Income Tax on Capital Gains

The Income Tax Act specifies that gains/profits that result from the transfer of capital assets are liable to be taxed as income. To understand the concept of tax on capital gains, it would be better to look at the very definition of capital gains tax – which can be broken into three distinct parts as follows -

gains/profits that result from the transfer of capital assets

Part I – Profits/Gains

Part II – Transfer

Part III – Capital Assets

Now let us take up each part one at a time.

Part I – Profits/Gains

Capital Gains Tax Calculation is Easy

As you can very well understand, a profit or gain results when you sell anything for a sum of money that is more than the cost price paid for that thing. But the income tax concept of profit/gains goes slightly beyond the simple definition. For example, if you purchased a piece of land in 1990 for Rs 1,00,000 and sell it in 2010 for Rs 5,00,000, then your profit is Rs 4,00,000. Right?

Wrong!

How? What about the effect of inflation? The Rs 1 lakh that you invested in 1990 would be worth a lot less today. For this purpose, a cost inflationary index is used, for all transaction that are transferred after one year of acquisition. In addition, any money incurred to make an asset fit for sale, called the cost of improvement, are also added to the cost price of the asset.

What if you had not purchased the land yourself, and it was bequeathed/willed/gifted to you by your long lost grand uncle (lucky you!)? Since you had spent nothing on purchasing the land, does that mean the cost price would be zero? No, in this case, the cost of acquisition by the earlier owner will be taken into account.

The gains can either short term capital gains (STCG) of long term capital gains (LTCG), depending upon how long the asset is held before its transfer. The time period is 1 year for shares/stocks, and 3 years for all other assets (see the Important Update at the bottom).

Part II – Transfer

Again, contrary to popular (some would say, reasonable) perception, capital gains don not result only from the sale of an asset. The law specifies a number of acts, called transfer, which will attract an incidence of capital gains tax. Actually, the list is rather long, and space constraints would not allow listing all of it. Yet, it includes -

  • Sale or exchange (this is easy to understand)
  • Extinguishment of rights in a capital asset (such as termination of lease)
  • Compulsory acquisition by authorities, for example, confiscation by IT Department
  • Conversion of an Asset into trade stock. For example, if you are builder, and sell your own house as a part of your business.
  • Part performance of a contract of sale. For example, if you had sold a flat in 2005, and gave the possession to the purchaser (who also happens to be your cousin!) had started living there right away, without registering the deed. It would be treated as a transfer for the purpose of capital gains tax.
  • Transfer of rights in properties by societies and companies. An example would be when a society is formed for making or purchasing properties. The ownerships of individual flats are changed by changing the membership of the society.
  • Transfer of assets by a person(partner) to a firm, or by a body of individuals or association of persons.
  • Distribution of capital assets on dissolution. This works in a manner exactly opposite of the above point.
  • Distribution of capital assets or monies on the dissolution of a company to its shareholders.

Part III – Capital Assets

Capital assets includes properties of all kinds, but excludes -

  • trade stock, WIP and raw materials used for business purpose
  • personal items such as furniture, clothes and motor vehicles ( sorry to disappoint, but jewelry is a capital asset, even if it is for personal use)
  • agricultural land
  • specified government securities

Calculation of Capital Gains Tax

The rate at which the profits form transfer of assets will attract tax will differ depending on the type of asset, and the duration for which it is held before transfer. STCG is taxed at the nominal rate of taxation for the assessee. Thus, if your income is being taxed in the 30% slab, your LTCG will be taxed at 30%.

The calculation of LTCG becomes slightly complicated. You can chose not to

Capital Gains Tax Liability Calculation

avail the indexation benefit, and attract a 20% tax, or avail indexation, and attract a 10% rate. Lets take our earlier example, of the land that you had bought in 1990 ( 1st January) for Rs 1,00,000 and the current sale price is Rs 2,00,000.

Cost Price = Rs 1,00,000

Improvement cost = Rs 10,000

Therefore, total asset cost = Rs 1,10,000

Sale Price = Rs 5,00,000

Cost Inflation Index for 1990 = 172

Cost Inflation Index for 2010 = 632

Now, LTCG = 5,00,000 – (1,10,000x 632/172)

= Rs 96,300

Tax @ 10% = Rs 9,630.

Important Update

The government has proposed revised provision for capital gains in its direct tax code (DTC). Under the DTC, the government proposes to abolish the distinction between long term and short term capital gains. All capital gains will be aggregated, and the tax will be calculated at the marginal rate of taxation applicable, which could go up to as high as 30%. Thus, if you are in the 30% tax bracket, then in our example above, your tax liability would be Rs 28,890. The indexation benefit would continue to apply.

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8 Responses

  1. Your blog states :”You can chose not to
    avail the indexation benefit, and attract a 20% tax, or avail indexation, and attract a 10% rate.”
    Should that not be the other way around? My understanding is that LTCG calculated taking into account indexation would be taxed at 20%.

  2. hi sir
    u r very gud in this taxation.i just want to know that if i purchased one asset or property in 2009 and i just sold it in 2010.and i earned profit of 2 lacs.thn what would be my tax liability on it..just a simple question….

  3. What is the taxation for realestate for NRI ?

  4. Dear Sir,

    I want to know if a domain name is considered as capital asset in Indian income tax system ?

    Thank you

  5. A Wonderful site. Appreciate your effort.

    Thanks

    Rajesh C Menon
    Dubai

  6. hey Sid , u good in finance stuff as well

    i never knew inflation is also taken into consideration while calc captial gain tax

    1 quick question though….is there no capital gain tax on flats sold after 3 years of purchase?

    thnks
    Vicky
    http://www.vickyadvani.blog.co.in

    • Hi Vicky,

      I am glad you find the article useful. Your appreciative comments keep me going.

      About your question – If the flat (I am assuming it is self owned, residential flat) is sold AFTER three years, that would make it a long term capital asset, and the CAPITAL GAIN arising would be taxable.

      However, the capital gain is not taxable if
      1) the assessee purchases a residential flat/house within 1 year before the transfer or 2 years after the transfer
      2) constructs a residential flat/house within 3 years after the transfer, and the new house is not transferred within three years.
      3) the amt of CAPITAL GAINS is invested in specified securities, and the same are not transferred within 3 years. The amt is limited to Rs 50 lakhs.

      I hope that answers your question.