Capital gains are chargeable to tax under the head “Capital Gains” when specific conditions are met. First, there must be the existence of a capital asset. Second, this asset must be transferred during the previous year. Third, the transfer must result in the generation of capital gains. Finally, the resulting capital gain must not fall under an exempt category. When all these conditions are fulfilled, the resulting gain becomes taxable as capital gains.
Understanding the Concept of Capital Asset
A capital asset is defined under section 2(14) of the Income Tax Act. The definition is inclusive, meaning it not only includes specific items listed in the section but also any property that fits the natural meaning of the term “capital asset.” It includes any property of any kind held by an assessee, regardless of whether it is connected to their business or profession. It also includes rights related to Indian companies, including management or control rights, and securities held by Foreign Institutional Investors that are compliant with SEBI regulations. Further, from the assessment year 2026-27, securities held by investment funds as per specified regulations will also be considered capital assets. Linked Insurance Policies to which exemption under section 10(10D) does not apply, for assessment years 2021-22 to 2025-26, and continuing from 2026-27, are also treated as capital assets.
Certain items are specifically excluded from the definition of capital assets. These include stock-in-trade other than securities, personal effects, agricultural land located in rural areas, and specific government bonds like Gold Deposit Bonds under the 1999 Scheme or deposit certificates under the 2015 Monetisation Scheme.
Personal Effects Not Treated as Capital Assets
Personal effects refer to any movable property held for personal use by the assessee or their family. Items such as furniture and clothing qualify as personal effects and are not considered capital assets. However, this exclusion does not apply to items like jewellery, archaeological collections, drawings, paintings, sculptures, or other works of art. Even if these items are for personal use, they are still classified as capital assets and thus subject to capital gains tax on transfer.
Agricultural Land in Rural India
Agricultural land situated in rural areas is excluded from the definition of capital assets. For land to qualify as rural, it must be located outside the jurisdiction of a municipality or cantonment board with a population of 10,000 or more, known as Area A. Additionally, the land must not fall within a specified distance from municipal limits, depending on population. If the population is between 10,000 and 1,00,000, land within 2 kilometers is excluded. For populations between 1,00,000 and 10,00,000, the exclusion zone extends to 6 kilometers, and for populations exceeding 10,00,000, the limit is 8 kilometers.
Classification of Capital Assets into Long-Term and Short-Term
Capital assets are divided into long-term and short-term categories based on their period of holding. As of July 23, 2024, assets held for more than 24 months are classified as long-term capital assets. However, specific financial instruments such as listed securities, units of equity-oriented mutual funds, listed debt-oriented mutual funds, and zero-coupon bonds qualify as long-term capital assets if held for more than 12 months. The shorter holding period for these financial assets allows more favorable long-term capital gain tax treatment within a relatively short investment timeframe.
Definition of Transfer in the Context of Capital Gains
Capital gains arise only when there is a transfer of a capital asset. Transfer includes actions like sale, exchange, relinquishment, extinguishment of rights, or compulsory acquisition under the law. However, certain transactions are not regarded as transfers and thus do not attract capital gains tax. These include distribution of assets on company liquidation, family partition of Hindu Undivided Families, gifts or inheritance, certain corporate restructurings involving holding-subsidiary company transfers, mergers, and demergers where the transferee is an Indian company. Additionally, specific transactions like redemption of Sovereign Gold Bonds or conversion of gold into Electronic Gold Receipts are also excluded from the definition of transfer.
Calculation of Short-Term Capital Gains
Short-term capital gain arises when a short-term capital asset is transferred. The computation involves deducting the cost of acquisition, the cost of improvement, and expenses related to the transfer from the full value of consideration received. The cost of improvement includes any expenditure made to enhance the asset after April 1, 2001. Any expense directly incurred to effect the transfer, such as brokerage or legal fees, is also deductible from the sale proceeds.
Calculation of Long-Term Capital Gains
Long-term capital gain arises from the transfer of long-term capital assets. The method of calculation is similar to that of short-term capital gains, with some key differences. The cost of acquisition and improvement is deducted from the full value of consideration, along with transfer-related expenses. However, in some cases, the cost may be indexed to account for inflation, thus reducing the taxable amount of gain. This indexed cost approach applies only to long-term capital assets and not to short-term assets.
Cost of Improvement and Its Relevance
Cost of improvement refers to capital expenditure incurred to enhance the value of the asset. For capital gains computation purposes, any improvements made before April 1, 2001, are not considered. Only the expenditure incurred on or after this date is eligible for deduction while calculating capital gains. The exclusion of earlier improvements simplifies the computation process and aligns it with modern valuation norms.
Instances Where Capital Gains Are Exempt
Capital gains are exempt under section 10 in certain specified cases. These include the transfer of units under US64, compulsory acquisition of urban agricultural land used for agricultural purposes, capital gains arising from the conversion of foreign bank branches into Indian subsidiaries under RBI schemes, and capital gains arising from land pooling schemes of the Andhra Pradesh Government. Under such schemes, exemptions apply to transfers of land, land pooling certificates, and reconstituted plots within specified timeframes. Amounts received under life insurance policies exempted under section 10(10D) are also not subject to capital gains tax. These exemptions provide relief in specific social or economic scenarios.
Transfer Where Cost to Previous Owner is Considered
In some cases, when the capital asset was acquired by gift, inheritance, or under specified corporate reorganizations, the cost of acquisition to the previous owner is considered for computing capital gains. Section 49 of the Income Tax Act provides that in situations such as family partition, inheritance, or transfer between related companies, the cost paid by the previous owner is used. In these cases, the holding period of the previous owner is also taken into account to determine whether the asset is short-term or long-term. This provision ensures continuity in tax treatment for assets that have not been purchased conventionally by the current owner.
Adoption of Fair Market Value as of April 1, 2001
If the capital asset was acquired before April 1, 2001, the assessee has the option to use the fair market value as of that date instead of the actual purchase price as the cost of acquisition. This option is beneficial in cases where the actual purchase cost is significantly lower than the value as of April 1, 2001. For land and buildings, the fair market value adopted cannot exceed the stamp duty value on that date. However, this option is not available for depreciable assets, goodwill, brand names, and other self-generated intangible assets. The use of fair market value ensures a more realistic computation of capital gains by reflecting market appreciation over time.
Types of Capital Assets
Capital assets are broadly classified into short-term and long-term based on the holding period. The classification determines the applicable tax rates and computation method. A capital asset is any property held by an individual, whether connected to a business or not. However, stock-in-trade, consumable stores, raw materials, and personal effects like furniture used personally by the assessee are not treated as capital assets.
Assets such as shares, securities listed on a recognized stock exchange, equity mutual funds, and units of the UTI are classified as short-term if held for 12 months or less. If held for more than 12 months, they are considered long-term. For real estate, unlisted shares, and debt mutual funds, the short-term threshold is 24 months, beyond which they are classified as long-term. For all other capital assets, the short-term period is 36 months. Assets like jewellery, paintings, and land are included in this category.
Cost Inflation Index and Indexed Cost of Acquisition
When calculating long-term capital gains, taxpayers can adjust the cost of acquisition using the Cost Inflation Index (CII). The CII accounts for inflation and increases the base cost, thereby reducing the overall capital gains. The formula to compute the indexed cost is: Indexed Cost of Acquisition = (Cost of Acquisition × CII of the year of transfer) / CII of the year of acquisition. This benefit is available only for long-term capital assets.
The Central Board of Direct Taxes (CBDT) notifies the CII annually. The base year was revised to 2001-02 with a CII of 100. For example, if an asset purchased in 2005-06 for ₹2,00,000 is sold in 2024-25, the indexed cost would be calculated using the respective CII for those years. This ensures that the inflation-adjusted cost is taken into account while computing capital gains, reducing tax liability.
Full Value of Consideration and Net Sale Proceeds
The full value of consideration refers to the amount received or receivable by the assessee on the transfer of a capital asset. This includes not just the sale price but any other consideration arising from the transfer, such as in the case of barter or exchange. In some cases, like transactions involving real estate, if the declared consideration is lower than the stamp duty value, the stamp duty value is considered as the full value of consideration under Section 50C.
To determine the capital gains, the cost of acquisition, improvement, and transfer expenses is deducted from the full value of consideration. Net sale proceeds = Full Value of Consideration – Expenditure incurred wholly and exclusively in connection with the transfer. Transfer expenses include brokerage, legal fees, advertising costs, and stamp duty paid by the seller. Only expenses directly related to the transfer of the capital asset are allowed as deductions.
Transfer of Capital Assets
The term ‘transfer’ in the context of capital gains tax includes sale, exchange, relinquishment, extinguishment of rights, and compulsory acquisition. It also includes the conversion of a capital asset into stock-in-trade and any transaction involving possession of immovable property under Section 53A of the Transfer of Property Act. Gifts and inheritance are not considered transfers for capital gains purposes, except under certain specific provisions.
Special provisions apply in cases like dissolution of partnership firms, demergers, amalgamations, and conversions of firms to companies. For instance, conversion of a partnership firm into a company is not regarded as a transfer, provided certain conditions under Section 47 are met. In compulsory acquisition by the government, the date of transfer is the date of possession, and capital gains are chargeable in the year of receipt of compensation.
Capital Gains on Sale of Property
When an individual sells real estate, such as land or a building, the gains arising are subject to capital gains tax. The type of capital gain—short-term or long-term—depends on the holding period. If the property is held for more than 24 months, gains are considered long-term and are eligible for indexation benefits. For short-term gains, the entire profit is added to the individual’s income and taxed as per the applicable slab rates.
For long-term gains, tax is charged at 20% with the benefit of indexation. In case of sale of residential property, Section 54 allows exemption if the proceeds are reinvested in another residential house within a specified time. If the new house is sold within three years, the exemption claimed earlier is revoked and taxed as capital gains in the year of sale.
The consideration received is compared with the stamp duty value of the property. If the declared sale value is less than the stamp duty valuation by more than 10%, the stamp duty value is considered as the sale value under Section 50C. This provision is aimed at curbing the practice of undervaluing property transactions to evade tax.
Capital Gains on Sale of Shares and Securities
Capital gains arising from the sale of equity shares and equity mutual fund units are classified based on the holding period. If held for more than 12 months, they are considered long-term. Gains exceeding ₹1 lakh in a financial year are taxed at 10% without indexation under Section 112A. Gains up to ₹1 lakh are exempt. For short-term gains, tax is levied at 15% under Section 111A.
For unlisted shares and debt mutual funds, the holding period threshold is 24 months. Long-term gains on these are taxed at 20% with indexation, while short-term gains are taxed as per slab rates. The grandfathering clause introduced in Budget 2018 ensures that gains accrued up to January 31, 2018, are not taxed. The cost of acquisition is taken as the higher of actual cost or the fair market value on January 31, 2018, capped at the sale value.
Capital Gains on Inherited or Gifted Property
In the case of assets received through inheritance or gift, the cost of acquisition for computing capital gains is deemed to be the cost at which the previous owner acquired it. This concept is referred to as the cost to the previous owner. The period of holding of the previous owner is also considered in determining whether the gain is short-term or long-term.
Although there is no capital gains tax at the time of receiving the asset as a gift or inheritance, tax becomes applicable when the recipient sells the asset. Exemptions under Sections 54, 54EC, and 54F can be claimed, provided conditions are fulfilled. The benefit of indexation is available based on the date of acquisition by the original owner, which often leads to a significant reduction in tax liability.
Exemptions Under Section 54, 54F, and 54EC
Section 54 provides an exemption from long-term capital gains tax on the sale of a residential house if the proceeds are used to purchase or construct another residential house within a specified time. The new house must be purchased within one year before or two years after the date of sale, or constructed within three years. The exemption is limited to the amount invested in the new house.
Section 54F applies to the sale of any long-term capital asset other than a residential house. The entire sale proceeds must be invested in one residential house to claim the full exemption. If only a part is reinvested, a proportionate exemption is allowed. The taxpayer must not own more than one residential house (other than the new one) at the time of transfer to avail this exemption.
Section 54EC – Capital Gains Exemption on Sale of Land or Building
Under Section 54EC, if long-term capital gains arise from the transfer of land or building or both, and the taxpayer invests the capital gain within 6 months in long-term specified bonds, then the capital gain will be exempt to the extent of the amount invested. These bonds are issued by the Rural Electrification Corporation (REC), National Highways Authority of India (NHAI), Power Finance Corporation (PFC), or Indian Railway Finance Corporation (IRFC). The maximum amount eligible for investment is Rs. 50 lakhs in a financial year. These bonds have a lock-in period of 5 years. The bonds must not be transferred, converted into money, or used as security before 5 years from the date of acquisition. The exemption amount is the lesser of the capital gains or the amount invested in these bonds. If the invested bonds are transferred or converted before the end of 5 years, the exemption claimed earlier will be withdrawn and taxed in the year of such transfer or conversion.
Section 54F – Capital Gains Exemption on Sale of Any Asset Other Than a Residential House
Section 54F applies when an individual or Hindu Undivided Family (HUF) sells a long-term capital asset other than a residential house and invests the net consideration in a residential house property. The exemption is available if the taxpayer does not own more than one residential house (excluding the new house) on the date of transfer and does not purchase or construct another residential house within a specified time frame. The investment must be made within 1 year before or 2 years after the date of transfer for purchase or within 3 years for construction. The exemption is calculated as: Exemption = Long-Term Capital Gain × (Amount Invested in New House ÷ Net Consideration). If the entire sale consideration is not invested, a proportionate exemption is allowed. If the new residential house is transferred within 3 years of its purchase or construction, the exemption is withdrawn and taxed in the year of such transfer.
Section 54B – Exemption on Sale of Agricultural Land
Section 54B provides relief when capital gains arise from the transfer of agricultural land used by the individual or parents for agricultural purposes in the 2 years immediately preceding the date of transfer. The exemption is allowed if the taxpayer purchases another agricultural land within 2 years from the date of transfer. The amount of exemption is the lesser of the capital gain or the cost of new agricultural land. If the new agricultural land is transferred within 3 years from the date of its acquisition, the exemption claimed earlier is withdrawn and taxed in the year of transfer.
Section 54D – Capital Gain on Compulsory Acquisition of Land and Building
Section 54D deals with the capital gains arising from the compulsory acquisition of land and buildings forming part of an industrial undertaking. To avail exemption, the asset must have been used by the assessee for business purposes for at least 2 years before its compulsory acquisition. The capital gain will be exempt if the amount is reinvested in purchasing or constructing another land or building for industrial purposes within 3 years from the date of receipt of compensation. The exemption amount is the lesser of the capital gain or the cost of new land or building.
Section 54G – Shifting of Industrial Undertaking from Urban Area
Section 54G provides an exemption on capital gains when an industrial undertaking located in an urban area is shifted to a non-urban area. The exemption applies to capital gains arising from the transfer of land, buildings, plant, or machinery. The exemption is available if the amount is reinvested in acquiring new land, building, plant, or machinery in the new location, or in expenses incurred for shifting the establishment and reinstallation of the undertaking. The reinvestment must be made within 1 year before or 3 years after the transfer. The exemption is equal to the amount reinvested or the capital gain, whichever is lower. If the new assets are transferred within 3 years, the exemption is withdrawn.
Section 54GA – Shifting of Industrial Undertaking from Urban Area to Special Economic Zone (SEZ)
Section 54GA provides an exemption when an industrial undertaking is shifted from an urban area to a Special Economic Zone. The exemption applies to the capital gains arising from the transfer of assets such as land, buildings, plant, or machinery. To claim the exemption, the assessee must reinvest the capital gain in the purchase of new assets or in expenses related to shifting and reinstallation in the SEZ within 1 year before or 3 years after the transfer. The exemption is limited to the amount reinvested or the capital gain, whichever is less. If the reinvested asset is sold within 3 years, the exemption is revoked.
Section 54GB – Exemption on Transfer of Residential Property for Investment in Eligible Start-ups
Section 54GB offers exemption from capital gains tax when the proceeds from the sale of a residential property (house or plot of land) are invested in the equity shares of an eligible company (including a start-up). This benefit is available to individuals and HUFs. The exemption is available if the investment is made before the due date of filing the return under Section 139(1). The company must utilize the amount to purchase new assets within 1 year from the date of subscription. The new company must be engaged in a business (except real estate, stock trading, etc.) and must not transfer the new asset acquired within 5 years. If the shares or the new assets are sold before the specified period, the exemption is withdrawn and taxed in the year of sale.
Capital Gains Tax on Sale of Immovable Property
Capital gains arising from the transfer of immovable property, such as land or buildingsarere subject to tax based on whether the asset is classified as a short-term capital asset or a long-term capital asset. The classification depends on the holding period of the asset. If the immovable property is held for 24 months or less, the gains are treated as short-term capital gains (STCG). If held for more than 24 months, the gains qualify as long-term capital gains (LTCG). In the case of LTCG, the indexation benefit is available, which adjusts the cost of acquisition according to inflation. This significantly reduces the taxable capital gain and the associated tax liability. The tax rate on long-term capital gains from immovable property is 20% (plus applicable surcharge and cess), while STCG is taxed at the applicable slab rate of the assessee. For computing LTCG, the following formula is used: LTCG = Full Value of Consideration – (Indexed Cost of Acquisition + Indexed Cost of Improvement + Transfer Expenses). For STCG, indexation is not allowed, and the cost of acquisition, cost of improvement, and transfer expenses are deducted directly from the sale consideration. Additional compliance requirements such as deducting TDS (Tax Deducted at Source) under section 194-IA by the buyer if the consideration exceeds ₹50 lakh,, must be observed.
Capital Gains Tax on Equity and Mutual Funds
The taxation of capital gains on listed equity shares and equity-oriented mutual funds underwent significant change post-Finance Act 2018. Short-term capital gains on listed equity shares and equity mutual funds (held for less than 12 months) are taxed at 15% under section 111A. Long-term capital gains (held for more than 12 months) were earlier exempt, but from FY 2018-19, such gains exceeding ₹1 lakh in a financial year are taxed at 10% without indexation under section 112A. To provide relief for investments made before this change, the government introduced the concept of grandfathering. The cost of acquisition for computing LTCG is considered the higher of the actual purchase price or the lower of the fair market value (FMV) as on 31st January 2018 and the full value of consideration received. This ensures that gains accrued up to 31st January 2018 remain exempt. Gains from debt mutual funds are taxed based on holding period and classification. Post amendments from April 2023, most debt mutual funds are taxed as per income tax slab rates regardless of the holding period. Earlier, gains on debt funds held for over 36 months were classified as LTCG and taxed at 20% with indexation.
Set Off and Carry Forward of Capital Losses
Taxpayers are allowed to set off capital losses against capital gains to reduce their tax liability. The rules for set-off and carry forward differ for long-term and short-term losses. Short-term capital loss (STCL) can be set off against both STCG and LTCG in the same year. Long-term capital loss (LTCL), however, can only be set off against LTCG. If there are unabsorbed losses after set-off in the current year, they can be carried forward for up to eight assessment years immediately succeeding the assessment year in which the loss was incurred. However, to avail the benefit of carry forward, the taxpayer must file the income tax return within the due date as specified under section 139(1). These losses must be reported in the tax return and substantiated with proper documentation. If not filed within the time, the taxpayer loses the right to carry forward the capital losses to future years. It’s also important to note that capital losses cannot be set off against income under any other head, such as salary, business income, or house property income.
Capital Gains Exemption for Agricultural Land
Gains from the sale of agricultural land in rural areas are not subject to capital gains tax. Rural agricultural land is not considered a capital asset under section 2(14) of the Income-tax Act. Such land must be located beyond a certain distance from the limits of a municipality or cantonment board, depending on the population of the area. For example, if the population is more than 10 lakh, the distance requirement is 2 km; for 1–10 lakh, it is 6 km; and for less than 1 lakh, it is 8 km. The sale of such rural agricultural land does not attract capital gains tax at all. However, if the agricultural land is located in an urban area, it is treated as a capital asset, and gains from its sale are taxable. In such cases, the taxpayer may still be eligible for exemptions under sections 54B, 54F, or 54EC if the required conditions are met.
Exemption under Section 54EC
Section 54EC provides an exemption from capital gains tax on the transfer of a long-term capital asset, being land or building or both, if the gains are reinvested into specified bonds. These specified bonds include those issued by the National Highways Authority of India (NHAI), Rural Electrification Corporation (REC), and other bonds notified by the government. The investment in these bonds must be made within six months of the date of transfer of the original asset. The maximum investment eligible for exemption under section 54EC is ₹50 lakh in a financial year. The bonds have a lock-in period of five years, and if they are transferred or converted into money before the expiry of five years, the exemption claimed earlier is withdrawn and becomes taxable in the year of such violation. Interest earned on these bonds is taxable, but the capital gain invested in these bonds is exempt to the extent of the investment.
Exemption under Section 54F
Section 54F allows exemption from LTCG tax on the sale of any capital asset other than a residential house if the net sale consideration is invested in purchasing or constructing a residential house. The exemption is proportional to the amount invested in the new house relative to the net consideration received. The entire LTCG is exempt if the entire net consideration is invested. If only a part of the consideration is invested, then the exemption is allowed proportionately. The residential house must be purchased within one year before or two years after the date of transfer or constructed within three years. The exemption is subject to several conditions. The taxpayer should not own more than one residential house (other than the new house) on the date of transfer. Also, the new property should not be sold within three years from the date of its purchase or construction. Violation of these conditions leads to the withdrawal of exemption and taxation of previously exempted capital gains.
Tax Implications for Non-Residents
For non-residents, capital gains arising from the transfer of capital assets situated in India are taxable in India. Non-resident Indians (NRIs) must pay capital gains tax on both STCG and LTCG based on the nature of the asset and the period of holding. LTCG from the sale of listed securities and mutual funds exceeding ₹1 lakh is taxed at 10% under section 112A. LTCG on sale of unlisted shares is taxed at 10% without indexation. LTCG on immovable property is taxed at 20% with indexation. STCG is taxed at applicable rates—15% for listed shares and equity mutual funds, and at slab rates for others. Tax deduction at source (TDS) provisions are strictly enforced for NRIs. For instance, 20% TDS (plus surcharge and cess) applies to LTCG on the sale of property. To claim deductions or refunds, NRIs must file income tax returns in India. They may also claim relief under Double Taxation Avoidance Agreements (DTAA) signed between India and their country of residence. However, proper documentation and tax residency certificates are mandatory for availing DTAA benefits.
Capital Gains and Real Estate Transactions
Real estate transactions are often subject to capital gains tax, and special rules apply for determining the cost of acquisition, period of holding, and sale consideration. When real estate is received as a gift or through inheritance, the cost of acquisition is considered to be the cost to the previous owner. The holding period is also determined from the date the previous owner acquired the property. This ensures continuity and preserves long-term classification if applicable. For transactions where the sale value declared is less than the stamp duty value (SDV), section 50C comes into play. In such cases, the SDV is deemed to be the full value of consideration for computing capital gains. However, if the difference between the actual sale consideration and the SDV is within 10%, the actual sale price is considered. Section 43CA applies a similar rule for real estate held as stock-in-trade. Also, under section 194-IA, the buyer must deduct TDS at 1% on the sale consideration if it exceeds ₹50 lakh. Compliance with these provisions is crucial to avoid penalties and notices from the tax department.
Advance Rulings and Judicial Precedents
Over time, several judicial rulings and advance rulings have helped clarify aspects of capital gains tax in India. Courts have ruled on issues like the determination of holding period, the applicability of exemptions in case of delayed construction, treatment of compensation received in compulsory acquisition, and interpretation of provisions like sections 50C and 54F. For instance, courts have held that booking a flat under a builder agreement qualifies as a purchase for section 54 benefits. Similarly, courts have accepted delay in construction due to the builder’s fault as a valid ground for exemption. The CBDT has issued clarifications that if the actual consideration is lower than SDV due to genuine reasonsuch as litigation, the taxpayer can appeal and provide a valuation from a registered valuer. These precedents help interpret the tax law in a taxpayer-friendly manner, but compliance with documentation and timelines remains essential to defend claims during assessment.
Conclusion
Capital gains tax is a critical aspect of income taxation in India. Understanding the nuances of computation, indexation, classification into short-term and long-term, and the various exemptions available is essential for effective tax planning. Provisions such as sections 54, 54F, and 54EC offer significant relief when investments are strategically made. Taxpayers, especially those dealing in real estate or financial assets, must ensure accurate reporting and proper documentation to avoid disputes with the tax authorities. With frequent amendments and judicial interpretations shaping the tax landscape, staying updated and consulting professionals when in doubt is highly recommended.