Capital Gains Exemptions: Everything You Need to Know

According to the Income Tax Act of 1961, citizens are required to pay taxes on gains arising from the transfer of capital assets like residential houses, shares, jewellery, etc. In order to determine the capital gains tax and capital gains exemption, factors like holding period, cost, indexation benefits and nature of the capital asset are taken into consideration. 

Another observation is that capital gains taxes are relatively lower than normal tax rates and added exemptions. On that note, let's dive deeper and understand capital assets, capital gains tax exemptions, and related concepts.

What are Capital Assets and Capital Gains?

According to Section 2(14) of the IT Act, a capital asset is any type of property owned by an assessee and can include land, buildings, vehicles, stocks, and other securities. Capital assets also include archaeological collections, jewellery, drawings, sculptures, paintings, etc.

Stock-in-trade, consumable supplies, raw materials, and movable personal effects, such as furniture and clothing retained for personal use by the taxpayer or members of their family, are not considered capital assets.

A capital gain (which eventually qualifies for capital gains tax exemptions) is a rise in the value of an asset that makes it worth more than the purchase price. As is the norm, any capital asset held for less than a year is classified as a short-term capital asset. A long-term capital asset would indicate any capital asset which is not short-term, which means the capital asset is retained for more than 12 months and is usually taxed at a lower rate.

What are Capital Gains Exemptions?

The need to pay capital gains tax arises when a taxpayer sells an asset (other than personal property and stock used in the business) for a profit. As a result, taxpayers who intend to buy or sell a capital asset must consider how the transaction will affect their tax situation.

Therefore, it is only fair that taxpayers can benefit from a reduction in tax incidence by being aware of the various Income Tax provisions and associated Capital Gains Exemption.

Section 54: Profit on sale of residential house

This section will help you gain full capital gains tax exemptions on the sale of a residential house that was self-occupied or rented, given the following points are met: 

• The assessee has either bought a new home one year before the sale of the old home, two years after the sale of the original home or is building a new home within three years of the sale of the previous home.
• The assessee has held the house for at least 3 years and is an individual or undivided Hindu family.
• The cost of the new house is reduced by the amount of capital gain exempted on the original house if the new house is sold within three years of the date of purchase or construction, and the difference in the sale price of the new house is regarded as a short-term capital gains exemption.
• If the cost of the house is at least more than the capital gain earned.
• If the related amount is to be deposited into the bank that falls under the preview of the Capital Gains 1988 account scheme

Section 54B: Short-term capital gain arising on transfer of agricultural land

This section talks about the short-term capital gain that arises out of a transfer of agricultural land. The capital gains tax exemptions are valid when the gain earned is reinvested into the purchase of agricultural land and the purchase is made within two years of the date of the previous transfer or sale.

As expected, if the capital gain is higher than the subsequent purchase value of the newly bought land, the remaining balance would be taxed, otherwise, no tax will be levied. Such similar Capital Gains Exemption is also levied on a long-term capital gain.

Section 54EC

This section deals with the capital gain invested in the long term specified assets of NHAI or Rural Electrification Corporation. Six months after the original asset's sale date, the assessee must invest all or a portion of the capital gain in certain assets, such as NHAI or REC bonds, with a three-year lock-in period.

The amount invested should equal the capital gain. If a portion of the gain is invested, the corresponding amount will fall under capital gains tax exemptions, while the other portion will be subject to tax.

Section 54F

This section deals with selling assets that are not residential houses, and the profit is used to buy residential houses. 

• One year before the asset's sale or two years after the sale, the assessee (an individual or a Hindu Undivided Family) purchased a new home. In addition, he has three years following the sale of the initial asset to building a house.
• The price of the new home must be less than the asset's selling price. Only the portion of the invested capital gain will fall under Capital Gains Exemption; the remaining portion will be subject to tax.
• If the entire sum is not used to build or purchase a home, it should be maintained in a bank account under the Capital Gains Scheme of 1988.
• The assessee should hold up to one residential property, excluding the new home, on the date the original capital asset is sold.

Frequently Asked Questions (FAQs)

What are the rules regarding the exemption of capital gains under Section 54D?

Gain resulting from government-purchased industrial property or structures is exempt from taxation. Prior to the acquisition, the asset was supposed to be used for industrial purposes for a minimum of two years. Only if the profits will be reinvested to purchase land or a building for industrial use is the Capital Gains Exemption permitted.

What Is Tax Loss Harvesting and How Does It Work?

In order to offset their capital gains and reduce their overall tax liability, taxpayers who use the tax loss harvesting technique sell listed shares or other financial instruments.

In this technique, taxpayers and investors sell their losing stocks or those whose market prices have decreased significantly since the date of acquisition and are not anticipated to recover or return to the price at which an investor had purchased the same. Liquidating their position is done just to record a loss, which lowers the gain for that particular tax year.

What are Indexation benefits, and when are they available?

By using the cost inflation index announced by the Central Government, indexation is a procedure by which the cost of acquisition is adjusted for the inflationary growth in the value of assets.

It's vital to remember that only a select group of long-term capital assets qualify for the indexation benefit. All bonds and debentures, with the exception of capital indexation bonds and sovereign gold bonds issued by the RBI, are not eligible for indexation benefits.

Which kind of gains from the transfer of land is exempt from taxes?

Section 54G inundates that gain resulting from the transfer of land, a structure, or equipment to relocate an urban enterprise to a rural location is exempt from taxation. The Capital Gains Exemption is permitted if the gain is invested in buying land, a structure, or equipment in a rural area.

Another avenue is provided by Section 54GA, where if the gain is reinvested to purchase land, buildings, or machinery in the Special Economic Zone, the gain resulting from the transfer of land, buildings, or machinery from an urban area to the Special Economic Zone falls under capital gains tax exemptions.