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What are the Capital Gains Exemption Under Section 54 of Income Tax Act

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The need to sell a house is common among homeowners for many reasons, including moving to a different city, changing careers, retiring, etc. Properties are also purchased and sold for investment purposes. As a rule of thumb, property owners tend to earn a profit on the sale of their properties. It is especially true if the owner has owned the property for a long time. According to Indian tax regulations, the profit earned in this way is considered a source of income, on which the income earner must pay taxes. Under section 54 of income tax act, exemptions from capital gains can be achieved by individuals or Hindu Undivided Family or HUF selling a residential property. So, let’s explore the exemption under section 54 of the Income Tax Act, as well as some frequently asked questions.

What are Capital gains?

Profits generated from the sale of an asset are known as capital gains. Stock market gains are derived from a stock’s difference in value between its purchase and sale price. A capital loss occurs when you sell an asset for less than you paid for it. Since the gain or profit is classified as “income” under Indian income tax laws, the person who profits from the sale must pay tax on the profit amount during the year in which the transfer of the capital asset took place.

What comes under Section 54 of Income Tax Act, 1961?

Capital gains are made when an asset is sold or transferred, and these gains are taxed in the taxpayer’s hands. A person or HUF selling a residential property can claim exemption from paying tax on such capital gains under Section 54 of Income Tax Act if they spend the sale proceeds to purchase or construct another residential property. For this tax benefit to be claimed, certain conditions must be met.

Section 54 of the Income Tax Act specifies that any person who sells a residential property and uses the proceeds to buy or build another residential property receives a capital gains tax benefit. Section 54 of Income Tax Act provides that a taxpayer is exempted from capital gains income tax on the sale of house property if they buy or builds another residential property within three years.

Capital Asset and its classifications

A capital asset is any property that an assessee owns. For example:

  • Immovable or movable: House, land, apartment, etc.
  • Fixed or circulating: Jewellery, machinery, etc.
  • Tangible or Intangible: Vehicles, trademarks, patents, etc.

When it comes to calculating capital gains, assets can be divided into two main categories:

  • Short-term capital assets: These are owned by an individual for a period of fewer than 36 months. Short-term capital gains are the profits made from the selling of these assets.
  • Long-term capital assets: Capital assets kept by the assessee for more than 36 months are long-term capital assets. Long-term capital gains are the profits made from the sale of these assets.

The house property must be held for more than 24 months to be considered a long-term capital asset under Section 54.

The eligibility criterion to avail benefits under Sec 54 of Income Tax 

They can claim tax exemption when an assessee sells a long-term capital asset, such as a residential home, and acquires another residential property. The following conditions must be met to qualify for this exemption:

  • This benefit is only available to individuals or HUFs. As a result of this part, the businesses are unable to benefit.
  • The property that the taxpayer is selling should be a long-term capital asset.
  • If you’re selling a house, be sure it’s a residential one. Rent should be charged under the heading rent from house property.
  • Either one year before or two years after the date of transfer, whichever comes first, shall be used to purchase the new residential property. Individuals who wish to buy a new property or build a new house have a three-year window from the date of transfer or sale in which to do so.
  • The taxpayer should buy a residential property in India.

A person cannot claim an exemption under section 54 if they do not meet any conditions above. 

Also Read: Claiming Deduction on Interest under Section 80TTA of Income Tax Act

Capital gain exemption under section 54f of Income Tax Act 

Individuals are allowed to deduct whichever of these amounts is lesser under section 54 of the income tax act:

  • Capital gain amount on residential property transfer
  • The investment is made for the construction or purchase of a new residential property.

The remaining money (if any) is taxable under the Income Tax Act.

For instance: If Mr X sold his house and made a capital gain of ₹ 50,00,000. He used the money from the sale to buy a new house for ₹ 30,00,000. According to section 54, the smaller of the two amounts, which is ₹ 30,00,000, shall be excluded. The capital gains that would be taxed will be the difference between the two, ₹ 20,00,000. ( 50,00,000-30,00,000).

Conditions (mandatory) for exemption under section 54:

To qualify for the exemptions under section 54 of the income tax act, the taxpayer should meet the following requirements: 

  • After selling the previous one, the assessee must purchase a new residential property or build a new housing property to qualify for this exemption.
  • It is required that the new residential property be purchased either one year before or two years after the sale of the old property or constructed within three years of the sale date.
  • To qualify for the benefit, a person can only build or buy one residential property at a time.
  • If one doesn’t want to buy the property, they can deposit the capital gains proceeds in a Capital Gains Account Scheme at any public sector bank.

Provisions related to sale/transfer of property within 3 years after claiming benefits under section 54f of income tax act:

  • According to section 54, an assessee who sells an existing long-term capital asset and buys or builds a new house within the stipulated time limit can claim an exemption.
  • A person who wishes to sell the new property they have purchased should hold it for a minimum of three years under section 54 of the law.
  • They must pay the tax on capital gains if they sell before the stipulated period has expired, and they will no longer be eligible for the benefit.

Within three years after the purchase or building of a new home, two things can happen. There are two ways to calculate taxability:

  • If the cost of the new property is less than the capital gains estimated from the sale of the previous house: In this instance, the capital gain exempted during the transfer of property is now taxable, and the cost of acquiring new assets is considered as zero.

Illustration:

Mr Kapoor sold a long-term residential property in July 2017, for which the capital gains were  60,00,000. In August 2017, he purchased another residential property for  40,00,000. Then, he sold this new property (Purchased in August 2017) in December 2018 for  45,00,000.

Calculation of the taxable component of his capital gains will be as below:

Financial Year (2017-2018) the first property was sold in July 2017:

Capital gains on the sale of the house

₹ 60,00,000

Minus: Exemption under section 54 on account of purchasing a new property 

₹ 40,00,000

Taxable long term capital gains

₹ 20,00,000

Financial Year (2018-2019)- the second/new property was sold in December 2018:

Sale amount for new property

₹ 45,00,000

Minus: Expense on the sale of the property 

NIL

Taxable short term capital gains (FY 18-19)

₹ 45,00,000

Because the new property was sold within three years of its purchase, its acquisition cost was zero. As a result, the total sale price will be taxable as capital gains.

  • When the cost of acquiring a new residential property exceeds the capital gains estimated on the sale of the existing residential property: Costs associated with purchasing a new property are reduced by the amount of exempted capital gain.

Illustration:

Mr Chawla sold a long-term residential property, and the capital gains were  45,00,000 in June 2017. In October 2017, he purchased a new property worth  55,00,000. In January 2019, he sold the new property for  65,00,000.

 Financial Year 17-18

Capital gains on the sale of the property

₹ 45,00,000

Minus: Exemption under section 54 on account of purchasing a new property 

₹ 45,00,000

Taxable long term capital gains

NIL

Financial Year 18-19   

Sale amount for new property

₹ 65,00,000

Minus: Expense on the sale of the property 

NIL

Minus: Cost of purchasing a new house ( 55,00,000-45,00,000*)

₹ 10,00,000

Taxable capital gains (FY 18-19)

₹ 55,00,000

*capital gain claimed for the original property

In layman’s terms, this means that if the new residential property is sold within three years of the date of acquisition or completion of construction, the exempt capital gains will be taxed.

Capital Gains Account Scheme

It is still possible to save tax if the assessee could not purchase or construct a new property before the due date for filing a return of income for the year of transfer and still wants to do so. Taxes on capital gains from the sale of a house can also be saved by investing the sale proceeds or the capital gains from the property in the Capital Gains Account Scheme with any public sector bank.

Capital Gains Account Scheme deposits are subject to several conditions set out in the Income Tax Act:

  • This is done in a bank branch that is authorized. Branches of banks in rural areas aren’t listed.
  • To avoid penalties, the deposition must be completed by the due date for submitting income tax returns.
  • Amounts deposited must be used to acquire or construct a home per the legislation.

It is important to note that the amount invested in the Capital Gains Account Scheme will be recognised as income of the previous year if it is not used within the specified time frame (from the date of transfer of the original asset).

Also Read: All You Need To Know About Section 143(1) of Income Tax Act

Conclusion

You may be eligible for tax deduction under Section 54, Income Tax Act, when selling a residential property. Long-term capital gains from the sale of a residential property can be taxed under this clause. Purchase or construction of a new residential property or putting the sale profits in a Capital Gains Account Scheme at any authorised/approved bank are the two ways to qualify for this benefit. 

We hope that through this article we have conveyed the impact of income tax on sale of house property.

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