Category: Investment Management

Capital Asset and How Capital Gains Tax with indexation can be of help to you

Capital Asset: A capital asset is an asset that can't be easily converted into cash in regular business operations. Examples include properties, land, and machinery, which aren't readily exchangeable for cash. For tax assessment purposes, not all assets fall under the category of capital assets. Exclusions encompass items like jewelry, art, or drawings, as well as business inventory, and agricultural land situated more than 8 kilometers from municipal limits with a population of fewer than 10,000.

Capital Gain: Capital gain refers to the appreciation in the value of an asset from its purchase price. This gain remains unrealized until the asset is sold. For example, if you invest Rs 1,00,000 in an equity mutual fund and it appreciates by 10% after one year, the gain is considered unrealized until you sell the asset. Once you sell it, the gain becomes realized and becomes subject to taxation. Capital gains are classified into two types: short-term and long-term.

  • Short-term Capital Gain: An asset sold before 36 months is considered short-term, but some specified assets can be categorized as short-term if held for 12 months or less. These include units of specified mutual funds, securities listed on recognized stock exchanges, units of Unit Trust of India, and equity or preference shares.
  • Long-term Capital Gain: Assets sold or transferred after 36 months from the acquisition date or 12 months in the case of specified assets are considered long-term capital gains.

Calculating Tax on Short-term and Long-term Capital Gains:

  • Short-term Capital Gains: The tax rate is based on the individual's income tax slab. For example, if you're in the highest tax bracket, you'll pay a higher tax rate on your gains.
  • Long-term Capital Gains: The tax rate is typically 10% on the gain or 20% on the gain after applying indexation benefits for specified assets. However, for properties, the tax rate is a flat 20% with indexation benefits.

Indexation in Long-term Capital Gains: Indexation accounts for the effect of inflation on the cost of an asset over time. It adjusts the cost of acquisition by considering an index known as the Cost Inflation Index (CII) published by the government each year. The formula for computing indexed cost of acquisition is: Sale consideration * CII for the year of sale / CII for the year of purchase. This reduces the capital gains tax by increasing the asset's acquisition cost due to inflation.

Example: If you bought a property for Rs 10,00,000 in June 2004 and sold it for Rs 20,00,000 in December 2009, this qualifies as a long-term capital asset sale. Using indexation, the indexed cost of acquisition is Rs 13,16,666, reducing the capital gains. Deducting additional expenses and agent fees from the sale consideration, you can calculate the taxable capital gains.

Exemptions and Other Considerations: There are exemptions available under different sections of the Income Tax Act to reduce or eliminate capital gains tax in certain cases. For instance, under Sec 54, Sec 54B, Sec 54D, 54EC, 54 F, and 54G, you can claim exemptions based on the type of property sold, helping to reduce the tax liability.

Inheritance also comes into play, with adjustments made for the cost of acquisition and the holding period, calculated from the date of transfer from the previous owner to the sale date.

It's important to note that these calculations differ for short-term and long-term capital gains, and understanding the type of asset and the corresponding taxation rules is crucial for effective tax planning.


(Contributed by Dilshad Billimoria BBM, LUTCF CFPCM, Certified Financial Planner and Investment Advisor)