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A beginner's guide to capital gains tax
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Disclaimer: This Article is for information purposes only. The views expressed in this Article do not necessarily constitute the views of Kotak Mahindra Bank Ltd. (“Bank”) or its employees. The Bank makes no warranty of any kind with respect to the completeness or accuracy of the material and articles contained in this Article. The information contained in this Article is sourced from empanelled external experts for the benefit of the customers and it does not constitute legal advice from the Bank. The Bank, its directors, employees and the contributors shall not be responsible or liable for any damage or loss resulting from or arising due to reliance on or use of any information contained herein. Tax laws are subject to amendment from time to time. The above information is for general understanding and reference. This is not legal advice or tax advice, and users are advised to consult their tax advisors before making any decision or taking any action.
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What do a person selling a house, a mutual fund and gold jewelry all have in common? Capital gains tax, of course!
If you have sold any capital asset at some point in your life, you may have paid this kind of tax to the government. But have you ever stopped to wonder what this tax is all about? Let’s find out.
First things first, what is a capital asset?
A capital asset under the Income Tax Act, 1961, is property of any kind held, whether or not connected with his business or profession. The assets that are not capital assets include stock-in-trade, personal effects, agricultural land, and some specified gold bonds.
So, by this definition, the following assets including others can be considered as capital assets:
What are capital gains?
When you sell any capital asset at a price that is higher than its purchase cost, you make a profitable sale. These profits are known as capital gains. You may unfortunately also incur a loss in the transaction and will be treated as capital loss.
For instance, let’s say you purchased a house in 2001 for Rs. 15 lakhs. And you sell it in 2022 for Rs. 55 lakhs. In this transaction, you make a profit of Rs. 40 lakhs — which are the capital gains arising from the sale (the entire amount is not taxable because of indexation, which we’ll discuss in an upcoming section)
Depending on the type of asset and the period of holding, capital gains can be of two types, namely short-term and long-term gains.
Short-term capital gains
Your profits are classified as STCG if the holding period of the capital asset sold is as follows —
Long-term capital gains
Your gains are classified as LTCG if the holding period of the capital asset sold is as follows —
And what is capital gains tax?
This one’s simple enough. It is the tax that is levied on your capital gains. The rate of tax depends on the type of asset and the type of capital gains. Check out the capital gains tax rates below for residents.
What is indexation and how does it work?
As you can see in the table above, some LTCGs are taxed at 20% with indexation. But what does this term mean? In simple terms, it is the process by which the purchase price of an asset or the cost of renovating it is adjusted for inflation.
Take Rs. 100, for instance. This sum of money may have definitely been worth more a few years back than it is now, because the value of money decreases with time. Indexation helps account for this when you compute your capital gains. To adjust the purchase price of an asset, we use a metric called the Cost Inflation Index (CII). The income tax department sets the CII for each financial year. The indexation benefit is allowable on sale of only certain long term capital assets.
And this is the formula we use to compute the indexed purchase cost of an asset —
Indexed Cost of Purchase = Original Purchase Cost * (CII of year of sale ÷ CII of year of purchase)
The long term capital gains are then calculated as the difference between the actual sale price and the indexed cost of purchase.
Computing capital gains: An illustrative example
Consider the following information regarding a hypothetical house property in your name.
So, using the above formula, the indexed cost of purchase can be calculated as follows:
Indexed cost of purchase:
= Original purchase cost X (CII of year of sale ÷ CII of year of purchase)
= Rs. 15,00,000 x (331 ÷ 100)
= Rs. 49,65,000
The long-term capital gains in this case would be:
= Actual sale price — Indexed cost of purchase
= Rs. 55,00,000 — Rs. 49,65,000
= Rs. 5,35,000
And the LTCG tax would be calculated at 20% of the gains, which is Rs. 1,07,000 (20% of Rs. 5,35,000).
Well, that’s about it then. This sums up the fundamentals of short-term and long-term capital gains taxes that you need to know.
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