What is a capital gain?
Any profit or gain that arises from the sale of a ‘capital asset’ is a capital gain. This gain or profit is charged to tax in the year in which the transfer of the capital asset takes place.
Capital gains are not applicable when an asset is inherited because there is no sale, only a transfer. However, if this asset is sold by the person who inherits it, capital gains tax will be applicable. The Income Tax Act has specifically exempted assets received as gifts by way of an inheritance or will.
Understanding Long term and Short term Capital Gains
There are various asset classes like equity, debt, gold, & real estate where you invest according to the time horizon of your goals and risk appetite. The gains from these investments are termed as capital gains and taxed differently. Since any tax liability impacts your returns from the investment, it’s important to have awareness of the net gains you will receive.
The capital gains from above-mentioned asset classes is classified as long term or short term based on the holding period of investment. For e.g. in real estate, if you have held the asset for more than 3 years it is treated as long term. Contrary to this in equities, investment for more than a year is treated as long term.
Here are some calculations to show how long term and short term capital gains are derived and how it can help in reducing your taxability:
- Long-term Capital Gains: A long-term capital gain arises when you hold an asset for a defined period. This period ranges from one year to three years across different asset classes. The table below shows the holding period for long-term gains in various asset classes and the applicable tax rate
As can be inferred from the data, equities enjoy zero taxability on long-term capital gains while in real estate or physical gold investment you have to pay a flat rate. Due to these variations, the post-tax returns from these asset classes can vary substantially. There are provisions in income tax to reduce LTCG through indexation or save LTCG tax from some of these instruments by investing it in other alternatives.
Indexation Benefit: Inflation constantly erodes the real value of money through a rise in prices. Due to this even if your investment have risen four times the purchasing power of money will have gone down 50% from the time you made an investment. To reduce the impact of inflation on your investment, indexation benefit is provided in calculating long-term capital gains. Through this benefit, you can adjust your capital gains from inflation by applying an appropriate factor from cost inflation index to the original units.
Here is how indexation benefits work:
Cost of purchasing a property in 2007- Rs 3500000
Cost of selling the property in 2011 – Rs 5000000
Inflation Index- 2007 – 551
2011 – 785
Indexed Purchase cost- 3500000*785/551= Rs 4986388
Long Term Capital Gains= 5000000-4986388 = Rs 13612*
Tax on LTCG= 13612*20%= Rs 2722
Education Cess= 2722*3% = Rs 82
Total Tax on LTCG = Rs 2804
*The non- indexed gain would have been Rs 15 lakh
Thus, the indexation benefit reduces the tax liability substantially which otherwise would have been a huge payout for any investor.
- Short Term Capital Gains: Investments in any asset class if held for a very short period is taxed as short-term capital gains. Except for equity, short-term gains from other assets are included in investor’s income and taxed at slab rate. The data below highlights the taxation structure in case of short-term capital gains:
*Education cess of 3% is applicable on all tax rates
This is how short-term capital gains are calculated:
Cost of Equity Mutual Funds units bought in 2011- Rs 100000
Price of same units sold after 6 months – Rs 120000
Short Term capital Gains – Rs 20000
Tax Applicable- 20000*15%= Rs 3000
Education Cess – 3000*3%=Rs 90
Total Tax payable= Rs 3090
With complex capital gains tax structure, it’s wise to first make yourself aware of the net returns i.e. post-tax returns you will earn, whenever you intend to make any investment. This will help in analyzing the amount of wealth creation you will create after paying your tax liabilities.