A beginner's guide to capital gains tax
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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:

  • Residential and commercial property
  • Stocks and securities
  • Jewelry
  • Archeological collections
  • Drawings and paintings
  • Sculptures and other works of art

 

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 —

  • 12 months or less, for listed securities and equity oriented funds
  • 24 months or less, for unlisted shares and real estate like land and building
  • 36 months or less, for debt funds and other assets

Long-term capital gains

Your gains are classified as LTCG if the holding period of the capital asset sold is as follows —

  • More than 12 months, for listed securities and equity oriented funds
  • More than 24 months, for unlisted shares and real estate like land and building
  • More than 36 months, for debt funds and other assets

 

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.

Nature of capital gains tax Applicable tax rate
Long Term Capital Asset 10% on gains above Rs. 1 lakh or 20% with indexation, as applicable depending upon type of capital asset
Short Term Capital Gains 15% or at the income tax slab rate as applicable depending upon the type of capital asset applicable.

 

 

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.

Particulars Details
Date of purchase  April 10, 2001
Financial year of purchase 2001-02
Original purchase cost Rs. 15 lakhs
CII for year of purchase 100
Date of sale August 11, 2022
Financial year of sale 2022-23
Sale price Rs. 55 lakhs
CII for year of sale 331

 

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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