When an investment property was sold by Ashok in October 2016, he had 6 months to invest in Sec 54EC capital gains bonds to avail tax exemption on the capital gains arising from the sale of his property purchased in June 2005.

To avail Sec 54EC exemption, the entire capital gains that arise from sale of the property after indexation benefits are applied, should be invested in bonds specified by the Government(NHAI, REC, NABARD) for a period of three years.

Indexation benefit is a benefit the Income tax  authority offers, whereby, using indexation figures one can inflate the cost of acquisition of the property. The indexation figures (where the index rates normally increase by the rate of inflation every year)  are published by the Income Tax Authority every year. BY applying the indexed figures, the cost of acquisition goes up, thereby reducing the capital gains amount and tax to be borne by the individual.

The investment in the specified capital gains bonds, must be done within 6 months from the transfer of the asset or the date of signing the sale deed.

The individual will receive an interim annual interest of 7-8% which is taxable. The investment is locked for 3 years. However, at the end of three years, the entire capital gains amount would be free tax and the individual can invest or do whatever he/ she deems fit.  Sounds good?

We advised Ashok to invest the capital gains amount in NHAI / NABARD or REC  capital gains bonds to avoid payment of capital gains tax.  But there was a question from the client and a lurking suspicion  from us “what if I get done with the tax payment” and invest the balance. “How would that option look?”   

We were initially convinced investing in capital gains bonds was the best option, because the base to start with initially, itself was higher in the capital gains investment. (where the entire capital gains amount needs to be invested in 54EC bonds)  But on digging deeper, and doing various scenario analysis, realised; there could be an option where he could earn more in another instrument even after paying the capital gains tax, and his investment would yield higher returns than the capital gains bond investment, after 3 years.

The capital gains tax rate is 20.4% (plus surcharge applicable) on the capital gains amount.

Below is the case study we worked on

Sale Consideration Rs 1,15,00,000
Sale Date Oct 2016
Purchase Cost Rs 30,00,000
Purchase Date June 2005

Indexation figures

Year of Sale : FY 16-17 1140
Year of Purchase:  FY 05-06 497

Capital Gains Amount after applying indexation is Rs 46,18,712

The three different scenarios we worked on-

  1. Pay capital gains tax at 20.4% and invest the balance in AAA rated Corporate FDS offering giving 8% taxable interest.
  2. Pay capital gains tax at 20.4% and invest the balance in Safe fixed income Debt funds- short term, medium term, dynamic and long term debt funds, assuming a 9% return with indexation benefit
  3. Dont pay tax and invest the entire capital gains in capital gains bonds- the first option we had assumed.

In Scenario 1, and 2, only the amount after payment of capital gains tax is available for investment.  Whereas in scenario 3 the entire capital gains amount forms the base for investment. So it looks that much tougher; to beat the capital gains bond investment returns.

In scenario 1, after payment of capital gains tax, the amount available for investment in AAA rated corporate bonds is RS 36,76,495. Interest rate assumed is 8%.We further calculated; what would be the net of tax returns for a person in 20% tax bracket and 30% tax bracket in this scenario after 3 years.

At 20% tax bracket, the investor made Rs 44,38,944 and at 30% tax bracket, the investor made  Rs 43,42,011 after three years net of tax.

In Scenario 2,  after payment of capital gains tax, the amount available for investment in safe fixed income debt funds  is the same- RS 36,76,495. Since investments in fixed income debt funds are only subject to long capital gains tax, irrespective of the tax bracket, we calculated the net of tax returns after applying indexation benefit .Interest rate assumed is 9% and returns post tax was Rs 46,75,813. Yippe, option 2 is better (for now only!)

In Scenario 3, the entire capital gains amount which is Rs 46,18, 712 is assumed to be invested in capital gains bonds yielding 7% taxable returns.

Returns after 3 years in this option at 20% tax bracket is Rs 53,22,746 and at 30% tax bracket is Rs 52,28,346.

A whopping Rs 552000 gain by investing in capital gains bonds, in the 30% tax bracket even if the interest earned is lower at 7%!

The client is still adamant – He wants to pay off the tax and invest the balance.

So here comes scenario 4!

We compiled an asset allocation investment mix of debt and equity yielding him 12.5% returns per annum for 3 year. The portfolio was designed  such that returns would be tax free.

In this asset allocation, even with a lower investment base of Rs 36,76,495 The client makes a return of Rs 52,34,697 tax free after 3 years.

Returns in scenario 3 (capital gains bond investment) is Rs 52,28,346.

Bingo! a gain of Rs 6351 in  scenario 4 even with a much lower investment base.

Conclusion- It isn’t always in your best interest to save capital gains tax by investing in capital gains bonds . One should compare post tax returns from alternative investment instruments before deciding to where to invest. Also if one is unable to create an investment portfolio with 12.5% per annum investment returns tax free,(since markets do fluctuate) then investing in the capital gains bond is a better option.

Dilshad Billimoria CFP

Chief Planner Dilzer Consultants Pvt Ltd