If you have recently sold a residential home (less than 6 months ago) and have made long term capital gains on the sale, then you are liable to pay long term capital gains tax.
A common query is how to avoid paying this tax.
There are 2 options here and you can utilize both of them.
The first is to buy or construct a house.
If you buy or build a residential home one year prior to the sale of your home, or within 2 years after the sale of your home, then the amount you have spent on the new home is exempt from tax. Similarly, if you buy a plot of land, and build a house on it, then both the cost of the plot and of developing the land are exempt from tax, as long as they fall within the stipulated 3 year period of 1 year prior up to 2 years after the sale. Just remember that you should not transfer the new house within a period of 3 years from its purchase, else the exemption will no longer apply.
To put it very simply, if you sell your house to buy another house, capital gains are exempt up to the cost of the new house.
The second option is investment into bonds under Sec 54EC.
These are bonds issued by the National Highway Authority of India (NHAI), and the Rural Electrification Corporation (REC); they have a lock-in period of 3 years, and currently give a 6% p.a. rate of interest.
Interest is paid out on 30th June every year, for 3 years, and interest is taxable in the year that it accrues. Only the principal amount invested is not taxed. You can invest up to Rs. 50 lakhs in these bonds and save tax on the amount invested.
The option of investing into these bonds is available for Indian citizens, as well as for those NRIs who are investing from their NRO accounts (and are therefore not repatriating the funds abroad).
People tend to opt for a combination of the above, in an effort to save tax when transferring an asset.
But is this always the best option?
There are people who believe that saving the tax is not as beneficial an option as simply paying the tax, and investing straightaway into the equity markets. Let’s examine if this is true.
Consider the case of our favourite fictional case study character, Mr. Shah.
Mr. Shah, who is 45 years old, has recently shifted house as he wanted to be closer to work.
He sold his old flat for Rs. 2 crore.
He also indexed the purchase value of his old home (i.e., using the given indexation figures, he increased his purchase price on paper to account for inflation), and bought a new home for Rs. 1.50 crore.
That leaves him with Rs. 50 lakhs of long term capital gains.
Thus he is now closer to work, has a new home, and has Rs. 50 lakhs (pre tax) in the bank.
Since he has indexed the purchase price of his old home, he has to pay 20% tax on the long term capital gains. His tax payable comes to Rs. 10 lakhs. A friend of his tells him that instead of paying the tax, he should invest in the REC bonds, but Mr. Shah is not convinced. A return of 6% per year (pre tax) which comes to 4.20% per year post tax (as Mr. Shah is in the 30% tax bracket) is very low. Mr,. Shah feels that it doesn’t makes sense to get this low a return for 3 years and miss out on investing in the equity markets for these 3 years. He wants to know if it would be better to just pay the tax and invest in the equity markets right away to build his retirement corpus.
Scenario 1: Pay the long term capital gains tax, and invest the post tax amount into balanced mutual funds to build a retirement corpus for use at the age of 60.
Tax Payable: Rs. 10 lakhs
Post Tax Corpus: Rs. 40 lakhs
Invested in: Balanced Funds (65% equity exposure, 35% debt exposure)
Tenure of investment: 15 years, until the age of 60.
Assumed rate of return on balanced funds: 10% p.a.
When Mr. Shah retires, he will have Rs. 1.67 crore approximately to boost his retirement corpus – a tidy sum! He would also have paid Rs. 10 lakhs as tax.
Scenario 2: Invest in REC / NHAI bonds, save tax, invest in the equity markets after 3 years to build the retirement corpus
Investment into bonds: Rs. 50 lakhs
Interest on bonds: 6% p.a. (pre tax) i.e. 4.20% p.a. (post tax)
Interest payable: Annually
Actual Interest received per year: Rs. 2,10,000
This interest is invested into balanced funds when it is received.
Once the bonds mature, the entire maturity amount is then free for investment.
The first interest receipt is invested for 14 years, it grows to Rs. 8 lakhs approximately, by the time of Mr. Shah’s retirement.
Similarly the second interest receipt is invested for 13 years, and grows to Rs. 7.25 lakhs by the time of retirement.
The third interest receipt, and the initial principal amount which has now matured (i.e. Rs. 52,10,000) can be invested for 12 years. This amount comes to Rs. 1,63,50,000 approximately.
The total corpus built by the time of retirement is Rs. 1,78,75,000 approximately.
So, by investing in the bonds and saving tax, and investing the interest and maturity proceeds into balanced mutual funds, Mr. Shah has built a larger corpus (by Rs. 11.65 lakhs approximately) than if he had paid the tax and invested into balanced funds immediately.
What Should You Keep In Mind?
In this case study, Mr. Shah opted to save 20% tax (because he had indexed his house purchase price), and earn 10% per annum return thereafter.
However, in case he had not indexed the value of his home, and hence would have paid 10% tax, the numbers would have been a little different.
At 10% taxation, the tax payable would have been Rs. 5 lakhs. The post tax investible corpus would have been Rs. 45 lakhs and the corpus built by the time of retirement would have been Rs. 1.88 crore approximately after paying tax. He would also have paid Rs. 5 lakhs as tax
Even considering the taxes paid, this corpus is larger than Rs. 1.78 crore – which was the corpus built by investing in the bonds, saving tax, and then investing. See how just one point has changed the answer from ‘invest in the bonds’, to ‘don’t invest in the bonds’.
So if you are considering investing in these long term capital gains bonds, you have to check 2 things:
- Have you indexed the value of your house? If yes, you will pay 20% tax on the capital gains.
- What return would you earn on the alternate investment? This investment has to be made in line with your investment time horizon and with your risk appetite.
Once you know these details, you can do the math to see which is the better option for you.
Else, you can just speak to your financial planner who will give you a solution that is customized to your specific requirements.