How Do Capital Gains Taxes Work?

If you’ve recently sold a house or earned some good profits on your equity investments, congratulations! But with tax filing season having just gone by, you may have been faced with the possibility of paying taxes on your profits. In other words — capital gains taxes.

What are they, and how do they work? Let’s find out more about this, so you can plan your capital asset sales smartly and ensure you optimise your tax benefits while minimising your tax burden in the process.

First things first: What are capital assets?

A capital asset is any asset that you hold, either for the purpose of your investments or for the purpose of your business or profession. It can also include assets not held for investment purposes. Some common examples of capital assets are listed below —

• Land and building
• Any other house property
• Vehicles
• Stocks and securities
• Jewellery
• Mutual funds

What are capital gains?

Over the course of your life, you may accumulate different kinds of capital assets. And at different points, you may sell these capital assets for various reasons. For instance, you may sell your jewellery to meet an emergency financial outlay, like the cost of unexpected medical treatment. Or, you may sell a plot of land or the shares you own in order to capitalise on the profits.

When you sell a capital asset, the profits that you earn in the process are called capital gains, according to the Income Tax Act, 1961. For a capital gain to be earned, there are three key criteria that need to be met —

1. There should be a capital asset
2. It should have been transferred from one person to another
3. The transferor should have made a profit from such a transfer

How are capital gains taxed?

When you sell a capital asset at a profit, the gains are taxed under the head ‘capital gains.’ They are also generally not clubbed with your total income (there’s an exception to this, as you’ll see later). Rather, they are taxed separately at the rates specified for these gains. To determine the rate of tax, you first need to identify the type of capital gains earned.

Typically, depending on the period for which you held a capital asset before selling it, capital gains can be of two types.

Short term capital gains (STCG)

Your profits are classified as STCG if the holding period of the capital asset sold is as follows —

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

Long term capital gains (LTCG)

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

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

The rates of capital gains taxes in India

Now, depending on the type of asset and the nature of the capital gains, the Income Tax Act, 1961, specifies the following rates for capital gains tax.

Understanding indexation

When you sell a capital asset after several years of holding it, a huge part of the asset’s price increase can be attributed to inflation. For example, say you bought a plot of land back in the 90s for a meagre Rs. 1 lakh. Today, over two decades later, let’s say the plot of land is worth Rs. 80 lakhs.

This huge price increase can be traced back to inflation. And if you sell your capital asset now, you will earn huge profits. But correspondingly, the taxes will also be steep. That said, it is not fair to tax the seller for the effects of inflation. Recognising this, the Income Tax Act, 1961, offers indexation benefits on some long-term assets.

Indexation is the process by which your purchase cost is adjusted to account for inflation. It increases the purchase price on a pro-rata basis, thereby reducing the taxable gains. To compute the indexed purchase price, we make use of a factor called the Cost Inflation Index (CII). The government calculates this for each financial year.

Check out the formula for the indexed purchase price below.

How capital gains taxes work: An illustration

Before we wrap up, let’s look at an example to understand how indexation and capital gains taxes work. Consider the following information for a house property.

Conclusion

This should give you a clearer idea of what capital gains are and how they are taxed. So, the next time you are planning to sell a house property or any other capital asset, make sure you compute your capital gains right, so you are prepared for these tax liabilities. It also helps you with your tax planning exercise.