Section 54 of Income Tax Act – Capital Gains Exemption

Section 54 of Income Tax Act – Capital Gains Exemption

"Invest in property now, keep it for a few years and then sell it off for a higher price". This has been the mantra for individuals who look for secured, less risky and less volatile investments.

However, while designing their strategies, the most crucial component – tax planning is often forgotten. You can plan a sale of immovable property and reinvestment with planning for tax exemptions.

Introduction

Firstly, let us understand which portion of the income is taxable on sale of the property. Is it the entire amount received on the sale of the property?
The answer is NO.

In simple words, it is only the profit earned by the individual on the sale of the property that is taxable, and profit is the difference between the sale price and the cost of the asset.

A sale of a residential house is a sale of a capital asset, and the profit gets taxed as a capital gain.

The definition of capital asset under section 2(14) of the Income Tax Act includes property of any kind movable or immovable, tangible or intangible held by the assessee for any purpose.

As per the income tax act, for capital gains, assets are classified into two types depending on the holding period of the investment:
  • Short-term capital asset
  • Long-term capital asset

What are the benefits of an asset being classified as a long-term capital asset?

The primary benefit of an asset being termed as a long-term capital asset is that the assessee is eligible for the benefit of indexation. Moreover, certain exemptions are suitable only for long-term capital assets.

Exemption under Section 54

Under Section 54 of the IncomeTax Act, an individual or HUF selling a residential property can avail tax exemptions from Capital Gains if the capital gains are invested in purchasing or constructing the residential property.

Under Section 54 of the IncomeTax Act, an individual or HUF selling a residential property can avail tax exemptions from Capital Gains if the capital gains are invested in purchase or construction of residential property.

Taxpayers such as partnership firms, LLP's, companies or any other association or body cannot claim tax exemption under section 54. The conditions that need to be satisfied to avail the benefit of the said section are as follows:

  • The asset must be classified as a long-term capital asset.
  • The asset sold is a Residential House, and income from such a house should be chargeable as Income from House Property.
  • The seller should purchase a residential house either one year before the date of sale/transfer or two years after the date of sale/transfer. If the seller is constructing a home, the seller has an extended time, i.e. the seller will have to build the residential house within three years from the date of sale/transfer. In case of compulsory acquisition, will determine the period of purchase or construction from the date of receipt of compensation (whether original or additional payment)
  • The new residential house should be in India, and the seller cannot buy or purchase a residential home abroad and Exemption.
The above conditions are cumulative. Hence, even if one requirement is not fulfilled, the seller cannot avail of the benefits exemption under Section 54.

With effect from Assessment Year 2020-21 corresponding to FY 2019-20, a capital gain exemption is available to purchase two residential houses in India. Howe Exemption is subject to the capital gain not exceeding Rs 2 crore. An Exemption is available only once in the lifetime of the seller.

What is the Exemption available under Section 54 of the Income-tax Act?

The amount of Exemption under Section 54 of the Income Tax Act for the long-term capital gains will be the lower of:

  • Long Term Capital gains arising on transfer of the residential house, Or
  • The investment is made in the purchase or construction of a new residential house property. Hence, the balance capital gains (If any) will be taxable.

To illustrate:

  • Mr X sells his villa(house property) for Rs 45,00,000/-
  • With the proceeds of the sale, he purchases another villa for Rs 20,00,000/-
  • Capital Gains will be computed as follows
ParticularsAmt (Rs)
Capital gain on transfer of residential house45,00,000.00
Less: Investment made in residential house property20,00,000.00
Balance – Capital Gains25,00,00 Exemption will be lower of the Capital Gains (Rs 45,00,000) or investment in new property (Rs 20,00,000) Exemption will be Rs 20,00,000.

What are the provisions relating to the transfer of property after claiming benefit under Section 54?

If the new house is sold within three years from the date of purchase or construction,  Exemption claimed earlier under section 54 shall be indirectly taxable in the year of sale of the new house property. Let's consider two scenarios when the new house is sold within three years from the date of purchase or construction:

Case 1: The cost of the new house purchased is less than the capital gains computed on the sale of the original home.

Generally, when a house is sold, the profit is considered capital gains. However, when the new home is sold within three years from the date of purchase or construction, the acquisition cost will be regarded as Nil. Hence, there will be an indirect increase in taxable capital gains.

Example-

Mr Y sold residential house property in May 2015, and the capital gains amounted to Rs. 30,00,000/- In June 2015, Mr Y purchased a residential house property worth Rs. 18,00,000/-

Mr Y sold the new residential house property (Purchased in June 2015) in December 2016 for Rs. 35,00,000/-

Based on the facts mentioned above, let's compute the taxable capital gains for Mr Y . FY 15-16 (Property sold in May 2015)
ParticularsAmt (Rs)
Capital gain on transfer of residential house30,00,000.00
Less: Investment made in residential house property18,00,000.00
Balance – Taxable Capital Gains In FY 15-1612,00,000.00
FY 16-17 (Property sold in December 2016)
ParticularsAmt (Rs)
Consideration for transfer (Sale Consideration)35,00,000.00
Less: Cost of AcquisitionNIL
Balance – Taxable Capital Gains In FY 16-1735,00,000.00
Note:

As the new property for which deduction was claimed under Section 54 was sold in December 2016 (i.e. within three years from the date of acquisition), its purchase cost was considered NIL.

As a result, the entire sale consideration was considered as capital gains. Had the property been sold after three years, i.e. after June 2018, then in such case, the cost of acquisition would be available as a deduction, and capital gains would reduce.  

Case 2: The cost of the new house purchased is more than the capital gains computed on the sale of the original house

If the cost of the new asset purchased is greater than the capital gains, then it is evident that there will be no capital gains as the entire capital gains will be exempted. However, if the new house is sold within three years, then the cost of the new home will be computed as follows:  
ParticularsAmt (Rs)
Original CostXXXX
Less: Capital gains claimed for the earlier house propertyXXXX
Cost of the new houseXXXX

Example

Let's understand the above case with the help of an example. Mr Z has sold a residential house property, and the capital gains were Rs 25,00,000/- in June 2015.

In October 2015, Mr Z purchased a new residential house property of Rs 40,00,000/- In January 2017, Mr Z sold the new residential house Property for Rs 55,00,000/-

Based on the capital gains mentioned above, let's compute the taxable capital gains for Mr Z FY 15-16 (Property sold in June 2015)

ParticularsAmt (Rs)
Capital gain on transfer of residential house25,00,000.00
Less: Investment made in residential house property40,00,000.00
Balance – Taxable Capital Gains In FY 15-16NIL
FY 16-17 (Property sold in January 2017)
ParticularsAmt (Rs)
Consideration for transfer (Sale Consideration)55,00,000.00
Less: Cost of Acquisition (Refer Working Note Below)15,00,000.00
Balance – Taxable Capital Gains In FY 16-1740,00,000.00
Working Note 1: Computation of cost of acquisition (As sold the property within three years of purchase and Section 54 was claimed)
ParticularsAmt (Rs)
Cost of Acquisition40,00,000.00
Less: Capital gains claimed for earlier house property25,00,000.00
Cost of the new house (to be considered)15,00,000.00

What is the Capital Gains Account scheme?

Suppose the asset is sold in the PY, and the seller intends to but is yet to purchase the new house property as the time limit of 2 years or three years has not yet expired. In that case, the assessee is required to deposit the number of gains in the Capital gains account scheme (in any branch of the public sector, bank) before the due date for filing income tax returns.

The amount already incurred towards purchase/construction and the amount deposited in the capital gains account scheme can be claimed as a cost while claiming the deduction.

However, suppose the amount deposited in the Capital Gains Account Scheme is not utilized within the time limit mentioned. In that case, it shall be treated as income of the previous year in which three years expire (from the date of transfer of the original asset).

Section 54 v/s Section 54F

Earning income automatically casts a responsibility on the taxpayers to discharge income tax on such payment, and so is the case with capital gains. However, the income tax laws allow taxpayers to claim certain exemptions against capital gains, which will help reduce their tax outgo.

Two such very crucial exemptions one can claim are under Sections 54 and 54F. As discussed above, the Exemption under Section 54 is available on long-term Capital Gain on the sale of a House Property. Exemption under Section 54F is available on long-term Capital Gain on sale of any asset other than a House Property.

Standard requirements between the two Sections

  • A new residential house property must be purchased or constructed to Claim the Exemption.
  • Must purchase the new residential property either one year before the sale or two years after the sale of the property/asset.
  • Alternately, the new residential house property must be constructed within three years of the sale of the property/asset.
  • If you are not able to invest the specified amount in the manner stated above before the date of tax filing or one year from the date of sale, whichever is earlier, deposit the specified amount in a public sector bank (or other banks as per the Capital Gains Account Scheme, 1988).
  • Can only purchase one house property or construct Exemption for two properties for capital gains up to Rs 2 crore is only once in a lifetime benefit under Section 54.
Section 54Section 54F
To claim full Exemption, the entire capital gains have to be invested.To claim full Exemption, the entire sale receipts have to be invested.
If entire capital gains are not invested – the amount not invested is charged to tax as long-term capital gains.In case entire sale receipts are not invested Exemption is allowed proportionately.
[Exemption = Cost the new house x Capital Gains/Sale Receipts]
 You should not own more than one residential house at the time of sale of the original assExemption
Will reverse Exemption if you sell this new property within three years of purchase, and capital gains from the sale of the latest property will be taxed as the short-term capital gain exemptionWill reverse the Exemption if you sell this new property within three years of its purchase or construction OR if you purchase another residential house within two years of the sale of the original asset or construct a residential house other than the new house within three years of the sale of the original purchase. Capital gains from the sale will be taxed as long-term capital gains.
If the capital gains do not exceed Rs.2 crores, a once in a lifetime exemption is available for investment in 2 properties.No such exemption is available.

Key points to remember

  • If the new residential property cost is lower than the total sale, amount Exemption is allowed proportionately. For the remaining amount, you can reinvest the money under Section 54EC within six months. 
  • The property must only be bought in the seller's name and not in anybody else's name.
  • If the new residential construction builder fails to hand over the property to the taxpayer within three years of purchase Exemption is still allowed.








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