After selling my flat should I buy 54EC Tax Exemption Bonds or pay tax and invest in equity? 

Published: September 28, 2022 at 6:00 am

Last Updated on September 29, 2022 at 12:10 pm

A reader writes, “We are about to sell our flat. Many of my friends advise me to buy 54EC Capital Gain Tax Exemption Bonds to save tax and then invest the money. However, I wonder if paying the tax and investing the rest in equity is better. Can you please do a comparison study? Thanks to your articles, all my financial goals are in place, and I am regularly investing for them.”

54EC Capital Gain Tax Exemption Bonds can be used to avoid taxing long-term capital gains from selling property. The bond has to be purchased within six months of receiving the capital gain proceeds. The lock-in period is five years, and the bond’s interest rate is taxable as per slab. The maximum amount that can be purchased is Rs. 50 lakhs.

There are two aspects to paying tax and investing vs not paying tax and investing after five years.

  • Emotional: This is the most important aspect. Most people can’t handle their monthly income tax deductions at source. So they are unlikely to pay several lakhs of tax after a real estate sale (the most common use case). So for them, the choice is easy: Buy 54EC Capital Gain Tax Exemption Bonds and get on with it.
  • Technical: This applies to the rare few who can take an objective decision.

In what follows, we will present a technical comparison of the two choices knowing full well that most people would look to avoid “immediate loss” due to tax and buy the bonds.

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Update: I had earlier made a mistake in the calculation by not accounting for indexation properly. I thank Nitish Kumar Parmar and Amey Hedge of FB group Asan Ideas for Wealth for pointing this out. I have now updated the article.

  • Amount of capital gains: Rs. 50 lakhs after accounting for indexation.
  • Coupon Rate of 54EC Capital Gain Tax Exemption Bonds: 5% We will use the rate of the latest REC issue.
  • The tax rate on long term capital gains is 22.88% with indexation.
  • We will assume the total income from all sources, including interest from the section 54EC bonds, is Rs. 15 Lakhs. Such an assumption is necessary to determine the slab rate accurately.
  • Under the new tax regime, the relevant tax rule is “₹125000 + 25% of total income exceeding ₹12,50,000”. So the effective tax rate is 13%. So we shall assume 13% of the interest accused from the bonds will be lost to tax and not available for further compounding.
  • So the post-tax bond interest rate is  5%*(1-13%) = 4.35%. If we simply assumed a 25% slab rate with a 4% cess, we would get a post-tax rate of 3.7%, which is incorrect in our opinion.

Scenario 1: We buy section 54 EC bonds worth Rs. Fifty lakhs for five years. The post-tax corpus is Rs. 61.86 Lakhs.

Scenario 2: We pay tax on Rs. 50 lakhs. The remaining corpus is Rs. 38.56 Lakhs. This is now invested for five years. What is the post-tax rate of return required to at least get Rs. 61.86 Lakhs? Answer: 9.92%

Such a return is difficult to get unless we are adventurous enough for direct equity, equity funds or aggressive hybrid funds. Some less volatile options like:

  • Conservative hybrid funds
  • Balanced advantage funds
  • Corporate Bond funds
  • Equity savings funds

may fetch 9.92% post-tax, but it is a potluck.

Liquidity is an aspect most people ignore. A five-year lock-in period is quite fine for a person with a robust income and investment schedule for goals. Others may need access to the money anytime, so bonds may not be a good idea for them. Again, emotions would prevent us from thinking this way.

There are investors who “believe” that they can easily make more than 10% (post-tax) over five years. This is perfectly fine, and they can certainly avoid the bonds and work the capital immediately, provided they do not drown in regret if things go awry. However, avoiding tax with the bonds is the safer route as long as you have no immediate need for funds.

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