When you sell a capital asset - for instance, a residential apartment - the profit or gain you make from its sale is known as capital gain. You then have to pay tax on this gain, which is known as capital gains tax. Remember, the entire amount received on the sale of a property is not taxable; rather, it is only the profit earned by an individual on the sale of the property which is taxable.
Let us first understand the two types of capital gains:
Short-term capital gains: An asset (in our case – immovable properties such as land and building) held by its owner for two years or less is called a short-term capital asset. If you sell a property within two years from its purchase date (as mentioned on the registered sale deed) the income arising (profit) shall be treated as short-term capital gains.
Such capital gains are added to your taxable income and are then taxed according to the income tax slab applicable to you. There are no provisions available to save tax on these gains, and therefore, it is advisable that you hold your property for at least two years before selling it to avoid short-term capital gains tax.
Long-term capital gains: In case you sell a property after two years from its purchase date, the profit earned is known as long-term capital gain. These gains would be taxed at a rate of 20 percent. The key benefit of holding a property for more than two years before selling is that you, the seller, will get the benefit of indexation.
It is to be noted, however, that the criteria of the two-year holding period for immovable properties was changed from a three-year holding period since Financial Year 2017-18 (FY 17-18). Therefore, the gain from the sale of a property with a holding period of over two years will be treated as long-term capital gain only in cases when the property has been sold after March 31, 2017.
What is indexation?
Capital gains are determined by deducting the purchase price (at which you originally bought the property which you are now selling) from the sale price. However, for an asset such as residential property which has been held for a long time, it is not appropriate to calculate gains by simply deducting the purchase price from the sale price without paying any heed to the effects of inflation. Therefore, the concept of indexation is used.
Accordingly, the indexed purchase price or the indexed cost of acquisition is deducted from the sale price to calculate long-term capital gains. This is the reason behind indexation being applicable only for assets held beyond two years.
The indexed purchase price is usually higher than the original purchase price. This reduces the long-term capital gains and lowers the applicable Long-Term Capital Gains Tax (LTCG Tax).
To understand the calculation of LTCG Tax, we need to look at the individual components used in its calculation:
Sale price: This is the consideration to be received or already received by you, the seller, upon the sale of your property. Note that the capital gains are taxable in the year of transfer, even if the consideration has not been received.
Indexed cost of acquisition: The cost you incurred to purchase the property which you are now selling, but recalculated for inflation by the usage of the Cost Inflation Index (CII) as notified each year by the Ministry of Finance is the indexed cost of property acquisition. (The method of indexation is explained in the illustration given below). You can find the CII for each year, starting from FY 2001-02 till FY 2021-21 on the official website of the Income Tax Department of the Central Government.
Indexed cost of improvement: These are expenses of a capital nature incurred by you in making any additions or alterations to the property which you are now selling, such as upgradation of flooring material, installing a modular kitchen, among other similar expenses. This cost is also recalculated for inflation.
Associated expenses: These are expenses incurred exclusively and wholly in connection with the transfer of property, such as the commission paid to the broker, cost of stamp papers (stamp duty charges), and travel costs. In case you have inherited the property, expenses related to the procedure of going through with the inheritance and will could be allowed in some cases.
Calculation of Long-term Capital Gains Tax
Mrs. X purchased an apartment in August 2006 for Rs 40 lakh and went on to sell it in October 2019 for Rs 2 crore. She had also installed a modular kitchen in the same apartment in September 2018, which costed her Rs 3 lakh. For the sake of simplicity, we shall not be considering any associated expenses. Since this apartment has been sold after three years from the date of its purchase, this would be considered a long-term capital asset and the gain earned from its sale shall be treated as a long-term capital gain.
Indexed cost of acquisition = Cost of acquisition x CII for the financial year in which the property was sold
CII for the fiscal year in which the property was first held OR 2001-02 (whichever is later)
Indexed cost of acquisition = Rs 40,00,000 x 289
________________ = Rs 94,75,400 or Rs 95 lakh
Indexed cost of improvement = Cost of improvement x CII for the financial year in which the property was sold
CII for the financial year in which the improvement took place
Indexed cost of improvement = Rs 3,00,000 x 289
_______________ = Rs 3,09,642 or Rs 3.10 lakh
Long-term capital gains = Sale price – (Indexed cost of acquisition + Indexed cost of improvement + Associated expenses)
= 2,00,00,000 – (95,00,000 + 3,10,000)
= Rs 1,01,90,000 or Rs 1.01 crore
As we can see from the example, Mrs. X is liable to pay around Rs 20 lakh as LTCG Tax on the profit earned from the sale of her property. This is a hefty amount and can be lowered by making use of the exemptions offered under the Income Tax Act on long-term capital gains. To read more about the various exemptions, click here.