When an individual or a Hindu Undivided Family transfers a building or land appurtenant to it, which qualifies as a residential house and is a long-term capital asset, capital gains tax is typically applicable. However, the law provides an exemption if the long-term capital gains resulting from the transfer of the original residential house are reinvested in purchasing or constructing a new residential house within India, under specific conditions and within a set timeframe. This exemption is provided under Section 54 of the Income Tax Act. To qualify, the taxpayer must adhere to prescribed timelines, utilize the proceeds as directed, and ensure compliance with the rules laid out in the statute. The purpose of this exemption is to encourage reinvestment in housing and ease the tax burden on individuals who use the proceeds to secure another home.
Provision Under Section 54
Section 54 provides that where the capital gain arises from the transfer of a long-term capital asset, being buildings or lands appurtenant thereto and being a residential house, the income of which is chargeable under the head income from house property, and the assessee has within one year before or two years after the date on which the transfer took place purchased, or has within three years after that date constructed, one residential house in India, then instead of the capital gain being charged to income-tax in the year in which the transfer took place, it shall be dealt with as follows. If the capital gain exceeds the cost of the new residential house, the difference is taxed as income. If the cost of the new house equals or exceeds the capital gain, no tax is levied on the capital gain. For computing future capital gains on the new asset, the cost will be reduced accordingly. A proviso allows for investment in two residential houses if the capital gain does not exceed two crore rupees. However, this option can only be exercised once in a lifetime. Another proviso introduced with effect from April 1, 2024, caps the cost of the new asset at ten crore rupees to calculate the exemption.
Capital Gains Account Scheme
If the capital gains are not utilized for the purchase or construction of the new asset before the date of filing the return under Section 139, the unutilized amount must be deposited in an account under the Capital Gains Account Scheme before the due date of filing the return. The amount already utilized and the amount deposited will be treated as the cost of the new asset. If the deposited amount is not utilized within three years from the date of transfer, it will be taxed as capital gains in the year when this period expires. The assessee can then withdraw the balance from the scheme. The recent amendment also states that capital gains in excess of ten crore rupees shall not be taken into account for this sub-section, which limits the tax-free investment accordingly.
Amendment by Finance (No. 2) Act, 2014
Before the amendment by the Finance (No. 2) Act, 2014, the exemption allowed investment in a residential house. However, courts interpreted this provision liberally and permitted an exemption even for investments in more than one residential house. To curb this, the law was amended to restrict the exemption to one residential house situated in India. This amendment applied to Section 54 and also to Section 54F, aligning both provisions with the government’s intent to promote housing within India. This amendment took effect from April 1, 2015, and applies to assessment year 2015-16 onwards.
Amendment by Finance Act, 2019
To provide relief to taxpayers with long-term capital gains up to two crore rupees, the Finance Act, 2019, allowed them a one-time option to invest the capital gains in two residential houses in India instead of one. This concession can be availed only once in a lifetime and only if the capital gains from the sale of the original house do not exceed the specified limit.
Amendment by Finance Act, 2023
To restrict high-value tax exemptions being claimed by high-net-worth individuals, the Finance Act, 2023, imposed a cap of ten crore rupees on the cost of the new residential house for exemption under Section 54. If the cost of the new residential property exceeds ten crore rupees, the excess shall not be considered for exemption. This amendment also impacts the treatment of deposits under the Capital Gains Account Scheme. Any amount deposited under this scheme exceeding ten crore rupees shall not be considered for exemption. These provisions took effect from April 1, 2024, and apply to assessment year 2024-25 and subsequent years.
Highlights of the Provision
Section 54 applies only to individuals and Hindu Undivided Families and is available on more than one occasion during the lifetime of the assessee. The exemption is applicable only when capital gains arise from the transfer of a long-term capital asset, namely, a residential house or land appurtenant to it. The income from such property should be assessable under the head income from house property. If rental income is assessed under profits and gains of business or profession, the exemption may be disallowed. The assessee must purchase a new house within two years or construct one within three years from the date of transfer of the original house. The term purchase has been interpreted by courts to include taking possession of the house. The new asset must be located in India. Since the assessment year 2020-21, investment in two houses is allowed only if the capital gains do not exceed two crore rupees, and this benefit is available only once in a lifetime. Clarifications from the tax department have indicated that allotment of flats or houses by cooperative societies is to be treated as construction for this exemption.
Conditions Regarding Capital Gains Account Scheme
If the capital gains are not used for the purchase or construction of the new house before the date of filing the return under Section 139, they must be deposited in an account in a scheduled bank under the Capital Gains Account Scheme. The amount so deposited, along with the amount already used for the purchase or construction, will be treated as the cost of the new asset. If the funds are not utilized within the stipulated three years, the amount is deemed capital gains in the year the period ends. The assessee can then withdraw the funds as per the prescribed scheme.
Exemption Calculation Rules
If the capital gains are equal to or less than the cost of the new asset, the entire capital gain is exempt. If the capital gains are higher, the excess is taxed. If the new asset is transferred within three years, the cost for capital gains calculation is taken as nil, or is reduced by the amount of earlier exemption. This mechanism ensures that the benefit is not misused for short-term property transactions.
Rules Regarding Transfer and Investment
The exemption is also available where land is purchased and a house is constructed on it. However, if the new house is transferred within three years, the exemption is withdrawn. The cost of land and the construction are both taken into account while computing the cost of the new asset. Courts have ruled that even interior decoration or improvements can be included in the cost if necessary. The exemption may also be denied if the new house is not registered in the name of the assessee or if only payments have been made but no possession taken. Courts have, however, in many cases, accepted possession as sufficient proof of purchase.
Amendments Summary
The 2014 amendment restricted the exemption to one residential house in India. The 2019 amendment allowed, as a one-time relief, the benefit of investment in two residential houses in India if the capital gains do not exceed two crore rupees. The 2023 amendment limited the benefit to a maximum of ten crore rupees to curb the misuse of the exemption by high-net-worth individuals purchasing very expensive residential houses. All these amendments aim to ensure targeted use of the exemption and prevent its exploitation.
Circumstances Leading to Forfeiture
The exemption under Section 54 can be forfeited in two cases. First, if the amount deposited in the Capital Gains Account Scheme is not used for the purchase or construction of a new residential house within three years. Second, if the new residential house is transferred within three years of its purchase or construction. In either case, the earlier exempted amount will be taxed as capital gain in the year in which the condition is violated. This ensures that the exemption is used only for its intended purpose.
Time Limit Extension Due to Pandemic
The time limit for investment in the new house was extended to September 30, 2020, for those cases where the deadline expired between March 20, 2020, and September 29, 2020, due to the COVID-19 pandemic. This relief was granted under the Taxation and Other Laws (Relaxation and Amendment of Certain Provisions) Act, 2020, along with the notifications issued in June 2020. This extension was intended to ease compliance burdens during the national emergency period.
Conditions for Claiming Exemption Under Section 54
To claim the capital gains exemption under Section 54 of the Income Tax Act, certain conditions must be satisfied. Firstly, the asset that is sold must be a long-term capital asset. A long-term capital asset, in this context, refers to a residential property held for more than 24 months before its transfer. If the property is sold within 24 months, the gain will be treated as a short-term capital gainn and the Section 54 exemption will not apply. Secondly, the asset must be a residential house property. The exemption is available only when the capital gain arises from the sale of a residential house, which is a building or part of a building used mainly for residential purposes. It should not be a commercial property, nor should it be a plot of land. Thirdly, the individual or Hindu Undivided Family (HUF) must have either purchased or constructed another residential house. This is a key requirement. The exemption is only allowed if the assessee invests the capital gain in purchasing or constructing another residential property within the stipulated time frame. The property must be purchased either one year before or two years after the date of sale of the original asset. In case of construction, it must be completed within three years from the date of sale. The fourth condition involves the amount of exemption. The exemption is limited to the amount of capital gain or the cost of the new residential house, whichever is lower. If the cost of the new house is equal to or more than the capital gain, the entire capital gain is exempted. If the cost of the new house is lower, the exemption is limited to the amount spent.
Time Limit for Purchase or Construction of New House
Timing plays a crucial role in availing of the exemption under Section 54. The Income Tax Act specifies a time limit within which the new house must be purchased or constructed. For a purchase, the new residential house must be bought either one year before or within two years from the date of transfer of the original asset. This means that if an assessee has already bought a new residential house within a year before the date of sale of the original property, they are still eligible for the exemption. In case of construction, the new residential house must be constructed within three years from the date of transfer of the original asset. The law provides a relatively longer period for construction as compared to the purchase, recognizing the practical challenges and time required in building a house. It is important to note that merely entering into a construction agreement or paying advance money does not suffice. The construction must be completed within the specified time frame to claim the exemption. Similarly, if the taxpayer books a flat with a builder, the date of allotment by the builder is considered as the date of purchase for claiming the exemption. These timelines must be strictly adhered to; otherwise, the exemption claim may be disallowed by the tax authorities.
Amount of Exemption Under Section 54
The exemption under Section 54 is calculated based on the amount of capital gain and the cost of the new residential house property. The actual exemption is the lesser of the following two amounts: the capital gain arising from the sale of the original residential house, or the amount invested in purchasing or constructing the new residential house. For example, if the capital gain is ₹30 lakhs and the assessee invests ₹25 lakhs in the new house, the exemption would be limited to ₹25 lakhs, and the balance ₹5 lakhs would be taxable. On the other hand, if the investment is ₹35 lakhs, the entire capital gain of ₹30 lakhs would be exempt from tax. It is also important to remember that the exemption is available only against long-term capital gains. If the new house is sold within three years of its purchase or construction, the exemption claimed under Section 54 will be revoked. In such cases, the cost of the new house for computing capital gains will be reduced by the amount of exemption claimed earlier. This will result in a higher capital gain and increased tax liability. Hence, the taxpayer should avoid selling the new house within three years to retain the exemption benefit.
Deposit in Capital Gains Account Scheme
There may be instances where the assessee is unable to utilize the capital gains before the due date of filing the income tax return. In such situations, the Income Tax Act provides for a mechanism known as the Capital Gains Account Scheme (CGAS). Under this scheme, the unutilized portion of the capital gain can be deposited in a specified account with a bank before the due date for filing the return of income, which is generally July 31st of the assessment year. The amount deposited in the CGAS will be deemed to have been utilized for the purchase or construction of the new house. However, the deposited amount must actually be used for the intended purpose within the specified time frame—two years for purchase and three years for construction. If the amount remains unutilized after this period, it will be treated as capital gain of the year in which the time period expires. The taxpayer will then be liable to pay tax on such unutilized amount. It is therefore advisable to maintain proper documentation and keep track of the timeline when using the CGAS route.
Treatment When More Than One House is Purchased
Initially, the exemption under Section 54 was available only for the purchase or construction of one residential house property. However, the Finance Act, 2019,, introduced a significant change to this rule. Under the amended provisions, an assessee can now claim exemption for investment in two residential houses in India, provided the capital gains do not exceed ₹2 crore. This benefit of purchasing or constructing two houses can be availed of only once in a lifetime. If the taxpayer has already availed of this option once, they cannot claim the benefit again in the future, even if the capital gain in subsequent years is below ₹2 crore. This amendment was introduced to provide relief to middle-class taxpayers who may want to invest in two smaller houses instead of one larger house. It is also important to note that the exemption is available only if both properties are residential and located within India. Any investment in foreign properties is not eligible for exemption under Section 54.
Consequences of Selling the New House Within 3 Years
If the new residential house, purchased or constructed for claiming exemption under Section 54, is sold within three years from the date of its acquisition or completion of construction, the exemption granted earlier will be withdrawn. This is a critical provision that many taxpayers overlook. When the new property is sold within three years, the cost of acquisition of the new property, for the purpose of computing capital gains, shall be reduced by the amount of exemption claimed earlier. This means that the capital gain on the sale of the new house will be significantly higher, resulting in a greater tax liability. For example, if an assessee claims an exemption of ₹20 lakhs under Section 54 and then sells the new house within three years, the cost of acquisition will be reduced by ₹20 lakhs while computing the capital gains on such sale. This leads to an inflated capital gain figure, thereby increasing the tax burden. The implication of this provision is that the exemption is effectively converted into a deferment of tax, subject to the condition that the new asset is held for at least three years. Taxpayers must carefully plan their investment and holding period to avoid such tax consequences.
Exemption Available Only to Individuals and HUFs
Another important point to note is that the benefit under Section 54 is available only to individuals and Hindu Undivided Families (HUFs). It is not available to companies, firms, LLPs, or other types of assessees. This restriction has been placed to ensure that the benefit is extended only to genuine individual taxpayers and family units who are reinvesting their capital gains into residential accommodation for self-use or family use. Even among individuals and HUFs, the exemption is not automatic. It has to be claimed in the income tax return, and proper evidence such as purchase deeds, construction receipts, loan agreements (if any), and CGAS deposit proof (if applicable) must be submitted if demanded during scrutiny or assessment. Therefore, those intending to claim this exemption should maintain organized records of all transactions and legal documents related to the sale and repurchse,, or construction of residential houses.
Section 54 Exemption: Quantum of Exemption
The amount of capital gain that can be exempted under Section 54 depends on the amount of capital gains and the amount invested in the new residential property. The exemption under Section 54 is available to the extent of the amount of capital gains or the amount invested in the new house, whichever is lower. This can be explained with the following example. Suppose the long-term capital gain (LTCG) from the sale of the original residential house is ₹60 lakhs. The assessee purchases a new house for ₹45 lakhs. In this case, the amount of exemption under Section 54 will be ₹45 lakhs. If the new house is purchased for ₹75 lakhs, then the exemption will be restricted to ₹60 lakhs only, as it is the amount of capital gain arising from the transfer of the original asset. Therefore, the taxpayer needs to plan their investment carefully to maximize the benefit of the exemption.
Section 54: One House or Two Houses?
Section 54 originally provided an exemption only when the capital gains were invested in one residential house property in India. However, the Finance Act, 2019, introduced an amendment to provide relief to individual taxpayers having long-term capital gains up to ₹2 crore. The amendment allows the taxpayer to invest in two residential houses in India and still claim the exemption under Section 54. However, this benefit can be availed only once in a lifetime. If the assessee exercises this option, they cannot claim the benefit of investment in two residential houses again in future years. For example, if an individual earns a capital gain of ₹1.8 crore from the sale of a residential house and invests ₹90 lakh each in two different houses, they can claim the entire capital gain exemption. But this option is available only once. If in a later year the same individual sells another property and has capital gains, they will only be eligible to claim the exemption for one house. Taxpayers must plan wisely and use this one-time benefit at the most beneficial time.
Section 54: Conditions for Exemption
To claim the exemption under Section 54, the following conditions must be fulfilled. First, the capital gain must arise from the transfer of a long-term capital asset, which is a residential house property. Second, the asset must have been held for more than 24 months immediately prior to the date of transfer. Third, the individual or HUF must either purchase a new residential house property in India within one year before or two years after the date of transfer of the original asset. Alternatively, they may construct a new house within three years of the date of transfer. The new property must be situated in India. Investment in foreign residential property will not qualify for exemption under Section 54. Also, the new residential property must be a full purchase. Partial investments may lead to proportionate exemption. For example, if only 70% of the capital gain is invested in the new house, then only 70% of the capital gain will be exempt.
Consequences of the Sale of a New House
If the new house property purchased or constructed to claim exemption under Section 54 is sold within three years from the date of its acquisition or construction, the exemption claimed earlier will be withdrawn. In such a case, the cost of acquisition of the new asset shall be reduced by the amount of capital gain exempted earlier. As a result, the difference between the sale consideration and the reduced cost of acquisition shall be chargeable as short-term capital gain in the year of sale of the new house. For example, if a new house was purchased for ₹60 lakhs and the taxpayer claimed ₹40 lakhs exemption under Section 54, and later sold the house within three years for ₹80 lakhs, then the cost for computing capital gain would be ₹20 lakhs (i., ₹60 lakhs – ₹40 lakhs). The capital gain would thus be ₹60 lakhs and taxable as short-term capital gain, which is taxed at the applicable slab rate.
Section 54 and Capital Gains Account Scheme (CGAS)
Sometimes, the assessee may not be able to invest the capital gain in the new residential house before the due date of filing the return of income under Section 139(1). In such cases, the amount of capital gain must be deposited in the Capital Gains Account Scheme (CGAS) before the due date of filing the return. The amount deposited in the CGAS will be considered as an investment to claim exemption under Section 54. Later, the amount can be withdrawn from the CGAS for investment in the new house within the stipulated time period. If the amount deposited in the CGAS is not utilized for the purchase or construction of the residential house within the stipulated time, the unutilized amount shall be taxed as capital gains in the year in which the prescribed period expires. Therefore, proper documentation and timing of deposit and withdrawal from the CGAS are essential to retain the exemption benefit.
Judicial Pronouncements on Section 54
Over the years, courts and tribunals have interpreted the provisions of Section 54 in various ways. These judicial rulings provide clarity on key aspects of the section.
In the case of CIT v. J.R. Subramanya Bhat (1987), the Karnataka High Court held that the condition of construction of a new house within three years should be interpreted liberally. If the taxpayer could prove that construction had begun and substantial investment had been made, the exemption could be granted even if construction was not fully completed within the stipulated time.
Similarly, in Mrs. Seetha Subramanian v. ACIT (1996), the Income Tax Appellate Tribunal (ITAT) held that the purchase of a residential flat from a builder is treated as construction and not a purchase, thereby entitling the assessee to exemption under Section 54.
In CIT v. Sardarmal Kothari (2008), the Madras High Court ruled that even if the new property is purchased in the name of a close relative like a wife or son, exemption under Section 54 may be allowed, provided the investment was made by the assessee.
In Prakash v. ITO (2008), the Mumbai ITAT allowed exemption under Section 54 even though the new property was purchased before the sale of the original property, as long as it was within the prescribed period of one year.
These rulings reinforce the idea that Section 54 should be interpreted in a way that benefits genuine taxpayers who reinvest in residential property.
Conclusion
Section 54 of the Income Tax Act provides a significant tax relief mechanism to individuals and Hindu Undivided Families (HUFs) on long-term capital gains arising from the sale of a residential house. By allowing reinvestment in another residential property, this provision promotes continuous investment in housing and provides relief to taxpayers who seek to relocate or upgrade their living spaces.
It is crucial, however, to carefully adhere to the conditions laid down under the section, such as time limits for reinvestment, use of Capital Gains Account Scheme when required, and maintaining the new property for at least three years. Taxpayers should also keep detailed documentation to support their claim in case of scrutiny.