Capital Gains – Definition, Types, Classification, Calculation and Tax Exemptions on Capital Gains

Capital Gains – Definition, Types, Classification, Calculation and Tax Exemptions on Capital Gains

Every asset carries some value in it. Every investment has some return in it which can be both positive and negative. Similarly, there are returns on the capital asset or investment. To understand the concept of capital gains, let us first understand capital asset. The capital assets include those assets that is held by an individual. It can be related or unrelated with business or profession. Capital assets include houses, buildings, vehicles, jewelry, equity shares and mutual funds. Some of the assets that do not fit under the capital assets category are any stock, consumables or raw material, held for the purpose of business or profession, personal goods such as clothes and furniture held for personal use, Agricultural land in rural India, 6.5% gold bonds (1977) or 7% gold bonds (1980) or national defense gold bonds (1980) issued by the central government, Special bearer bonds (1991), Gold deposit bond issued under the gold deposit scheme (1999) or deposit certificates issued under the Gold Monetization Scheme, 2015. When a capital investment whether it is mutual funds or property is sold in the market exceeding its original price, the gain is referred to as the capital gain. Capital gains are generally taxable. The transfer of capital assets should take place in previous fiscal year in order to become eligible for the taxation during a financial year.

Capital Gains are classified according to their time horizon. The two types of Capital Gains are:

  • Short-Term Capital Gain
  • Long-Term Capital Gain

Short-Term Capital Gain are those gains that are realized after selling the assets within the purchase of 36 months whereas Long-Term Capital Gain are those gains that are realized after selling the assets by holding it for more than the 36 months period. Short Term Capital gains time frame are different for different set of assets. For example, the listed equity shares qualify for short term gains only if the time period is less than the 12 months. Beyond that it becomes the long-term capital gain. This rule also applies to preference shares, securities (like debentures, bonds, government securities etc.) listed on a recognized stock exchange in India, Units of UTI, whether quoted or not, Units of equity oriented mutual fund, whether quoted or not, Zero coupon bonds, whether quoted or not. For the scenarios of acquisition of assets using succession, inheritance, gift or will, the timeframe for which the asset was held by the former owner is also included while estimating whether it is a short-term capital asset or a long-term capital asset. Whereas for the cases of bonus shares or rights shares, the period of holding is taken into account from the date of allotment of bonus shares or rights shares respectively. After 31st March 2017, a holding period for non-moveable properties was changed to 24 months which implies for immovable assets like real estate, the time frame for short term capital gain is till 2 years and beyond that the gains become long term.

Capital Gains are computed based on the two factors: the kind of assets and their holding tenure. Let us look at a few terms whose familiarity is essential while calculating the capital gains on investments. The terms are Full value consideration, Cost of acquisition and Cost of improvement.

To understand the taxation of STT, let’s consider a simple example.

  • Full Value Consideration is the consideration received or to be received by the seller as a result of transfer of his capital assets. Capital gains are chargeable to tax in the year of transfer even when no consideration has been received.
  • Cost of acquisition is the value for which the capital asset was acquired by the seller.
  • Cost of improvement are the expenses of a capital nature incurred in making any modifications or changes to the capital asset by the seller.

After having gained the familiarity with the terminology, now let us understand how to calculate the capital gains. The method to compute the short-term capital gains is as follows. First, one should determine the Full value consideration. Then expenditure incurred wholly and exclusively in connection with transfer of ownership, Cost of acquisition and Cost of improvement should be deducted from the obtained value of Full value consideration. The resultant value is referred to as the Short-Term Capital Gain. The method to compute the long-term capital gains is also similar with some minor differences. First, one should estimate the Full value consideration. Then expenditure incurred wholly and exclusively in connection with transfer of ownership, Indexed Cost of acquisition and Indexed Cost of improvement should be deducted from the obtained value of Full value consideration. Lastly, the exemptions provided under sections 54, 54EC, 54F, and 54B are deducted from the resultant number. The final outcome is referred to as the Long-Term Capital Gain. For Long Term Capital Gain calculation, Cost of acquisition and improvement is indexed by applying CII (cost inflation index). This is done to adjust for inflation over the years of possession of the asset.

The Indexed cost of acquisition is computed as the ratio of the Cost of acquisition and Cost inflation index (CII) for the year in which the asset was first secured by the seller, or 2001-02, whichever is later times the cost inflation index for the year in which the asset is transferred.

Indexed Cost of Improvement is estimated as the product of Cost of improvement and Cost inflation index of the year in which the asset is transferred divided by the Cost inflation index of the year in which improvement took place.

As we have understood the manner in which the Capital Gains are computed. Now let us focus on the Tax Exemptions on Capital Gains and understand them in detail. Exemptions from taxations could be claimed on the capital gains under Section 54, 54EC, 54F, and 54B.

The Section 54 is about the exemption on sale of house property on purchase of another house property. The exemption on two house properties will be allowed once in the lifetime of a taxpayer, provided the capital gains do not exceed Rs. 2 crores. The taxpayer has to invest the amount of capital gains and not the entire sale proceeds. If the purchase price of the new property is higher than the amount of capital gains, the exemption shall be limited to the total capital gain on sale. The exemption can be availed subject to the following conditions are met: First, the new property can be purchased either 1 year before the sale or 2 years after the sale of the property. Second, the gains can also be invested in the construction of a property, but construction must be completed within three years from the date of sale. Third, In the Budget for 2014-15, it has been clarified that only 1 house property can be purchased or constructed from the capital gains to claim this exemption. Forth, note that this exemption can be taken back if this new property is sold within 3 years of its purchase/completion of construction.

The Section 54F is about the exemption on capital gains on sale of any asset other than a house property. This exemption is subject to the following conditions. One must invest the entire sale consideration and not only capital gain to buy a new residential house property to claim this exemption. Purchase of the new property should be made either one year before the sale or 2 years after the sale of the property. One can also use the gains to invest in the construction of a property. However, the construction must be completed within 3 years from the date of sale. This exemption can be withdrawn, if the new property is sold within 3 years of its purchase.

The Section 54EC is about the exemption on sale of house property on reinvesting in specific bonds. If one is not keen to reinvest profit from the sale of first property into another one, then he or she can invest them in bonds for up to Rs. 50 lakhs issued by National Highway Authority of India (NHAI) or Rural Electrification Corporation (REC). The invested money can be redeemed after 3 years, but they cannot be sold before the lapse of 3 years from the date of sale. With effect from the FY 2018-2019, the period of 3 years has been increased to 5 years. The property owner has six month of time period to invest the profit in these bonds. But to be able to claim this exemption, one should invest before the tax filing deadline.

The Section 54B is about the exemption on capital gains from transfer of land used for agricultural land. When one makes short-term or long-term capital gains from transfer of land used for agricultural purposes - by an individual or the individual’s parents or Hindu Undivided Family (HUF) - for 2 years before the sale, exemption is available under Section 54B. The exempted amount is the investment in a new asset or capital gain, whichever is lower. One must reinvest into a new agricultural land within 2 years from the date of transfer. The new agricultural land, which is purchased to claim capital gains exemption, should not be sold within a period of 3 years from the date of its purchase.

  • What is a Capital Asset?
  • The capital assets include those assets that is held by an individual. It can be related or unrelated with business or profession. Capital assets include houses, buildings, vehicles, jewelry, equity shares and mutual funds.

  • What do you mean by Capital Gain?
  • When a capital investment whether it is mutual funds or property is sold in the market exceeding its original price, the gain is referred to as the capital gain.

  • Are Capital Gains taxable?
  • Capital gains are generally taxable. The transfer of capital assets should take place in previous fiscal year in order to become eligible for the taxation during a financial year.

  • What is the difference between Short-Term Capital Gain and Long-Term Capital Gain?
  • Short Term Capital Gains are those gains that are realized after selling the assets within the purchase of 36 months whereas Long Term Capital Gains are those gains that are realized after selling the assets by holding it for more than the 36 months period.

  • Is there any exception for Short Term Capital Gain definition?
  • Short Term Capital gains time frame are different for different set of assets. For example, the listed equity shares qualify for short term gains only if the time period is less than the 12 months.

  • How Short-Term Capital Gains are calculated?
  • The method to compute the short-term capital gains is as follows. First, one should determine the Full value consideration. Then expenditure incurred wholly and exclusively in connection with transfer of ownership, Cost of acquisition and Cost of improvement should be deducted from the obtained value of Full value consideration. The resultant value is referred to as the Short-Term Capital Gain.

  • What is the difference between Cost of acquisition and Cost of improvement?
  • Cost of acquisition is the value for which the capital asset was acquired by the seller. Cost of improvement are the expenses of a capital nature incurred in making any modifications or changes to the capital asset by the seller.

  • What are the tax exemptions on Capital Gains?
  • Exemptions from taxations could be claimed on the capital gains under Section 54, 54EC, 54F, and 54B. The Section 54 is about the exemption on sale of house property on purchase of another house property. The Section 54F is about the exemption on capital gains on sale of any asset other than a house property. The Section 54EC is about the exemption on sale of house property on reinvesting in specific bonds. The Section 54B is about the exemption on capital gains from transfer of land used for agricultural land.