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When and How Capital Gains Tax Can be Reduced

Under certain circumstances, long-term or short-term capital gains tax to be paid can be significantly reduced. It is not routinely possible and therefore important to recognize this possibility if and when it arises. This post stems from a discussion at Facebook Group Asan Ideas for Wealth, started by Subrat Dash, with the circumstances explained by Ashal Jauhari and contributions by Harrsh Ankola.

For the purposes of this post, 80C shall refer to the sum of all deductions (eg. 80D, 80G ..._) possible under Chapter VI-A. So please treat 80C here as a nickname and not in the literal sense. Section 80C is far more recognizable than Chapter VI A!

For all the calculations we will consider a resident taxpayer, less than 60 years old.

Let us go through a series of Examples. Please note these examples are not everyday examples but can occur in certain instances. For example, a single earner making 1.5L a year can never invest 1.5L in an 80C instrument. But a second earner can if the primary earner handles all expenses.

All these examples are from numbers entered in ITR2. NOTE: Enter the basic information like age, nationality etc before using the form else it will not calculate.

Example 1: Total Income from Salary = 4 Lakh.

80C deduction = 1.5L

What is the taxable income?  4L - 1.5L = 2.5L.

What is the tax to be paid? Zero.

Example 2: Total Income from Salary = 1 Lakh.

What is the taxable income? Zero

Now suppose, 80C investment = 1.5L (the effective deduction allowed = 1L)

What is the taxable income?  Zero again.

Now, to arrive at this, would you

(a) Say 1 Lakh < 2.5 Lakh, so no taxable income

OR

(b) 1 Lakh  (salary)- 1 Lakh (80C) = 0. So no taxable income?

If you wish to complete reading the entire post (explained below), (a) vs (b) will come in handy. For now, leave it be.

Example 3: Total Income from Salary = 1 Lakh.

No 80C investments.

Taxable income = zero.

Suppose, there was a taxable long-term capital gain  (say from the sale of a house or debt fund etc.) or a short-term capital gain (all such gains are taxable) of say 3 Lakh, what is the taxable income.

Yes, yes it will not happen every financial year, but it can and as explained below I think it is the duty of the income tax department to account for it in a consistent manner.

When there are no 80C investments, there is no problem.

The income from salary = 1 lakh.

The tax-free income limit = 2.5 Lakh. Room in the tax-free bracket = 1.5L

Reported taxable capital gain = 3 Lakh.

The law permits you (and does this automatically in ITR forms) to take an amount equal to the room in the tax-free bracket from the capital gains and add it to the income.

So in this case the total income = 1L + 1.5L(from capital gains ) = 2.5L (there is no tax on this income)

The taxable capital gain is reduced to 1.5L. That is a significant reduction!!

Credit to Mr. Sundaram Anathkrishnan for educating on this a couple of years ago. He went to great trouble in digging out official example illustrating this. You can test this out in ITR2.

Example 4: Total Income from Salary = 1 Lakh.

Total 80C investments = 1 Lakh.

Taxable Capital Gain = 3 Lakh.

What is the taxable income and taxable capital gain?

This is what the IT department is doing:

First it computes net income as = 1L(salary) - 1L(80C) = 0

So the room in the tax-free bracket is the full 2.5L

So it says, taxable capital gain = 3L - 2.5L = 0.5L

Taxable income = Zero.

Let us do one more with arbitrary nos

Example 5: Total Income from Salary = 2,00,123

Total 80C investments = 99,877.

Reoprted Taxable Capital Gain = 2,51,239.

What is the taxable income and taxable capital gain?

The taxable income is already zero.

But the IT dept first calculates 2,00,123 - 99,877 = 1,00,246

Then it says, then tax free income limit = 2.5L So there is a room of
2,50,000 - 1,00,246 = 1,49,754.

It then deducts this "room" from the reported capital gain of 2,51,239.

2,51,239 - 1,49,754 = 1,01,485

So it say 1,01,485 (rounded to 1,01,490) is the taxable capital gain!

That is a reduction of nearly 60% in the taxable capital gain

Timeout: What follows is my opinion as to how the above calculation is flawed and that the tax outgo should be higher. In other words, an inaccuracy or a loophole if one can call it that. You can stop reading the post if you dont care for what I have to say - often a smart move.

What is my problem anyway?

Example 4 Revisited: Total Income from Salary = 1 Lakh.

Total 80C investments = 1 Lakh.

Taxable Capital Gain = 3 Lakh.

What is the taxable income and taxable capital gain?

The IT department deducts  2.5L from the capital gain of 3L because it computes the net income as 1L(salary) - 1L(80C) = 0

The 1L is already tax-free income and it is deducting the 80C investment from it.  This is similar to double-counting. A deduction from taxable income is applied to tax free income. Which I think is wrong.

When income is less than tax-free limit, 80C deductions have no relevance.

Therefore in this example, in my opinion, only 1.5L from capital gains should be added to income and the rest 1.5L is the taxable capital gain.

Since it deducts 80C investment from tax-free income, it is able to add 2.5L of the capital gains, resulting only in 0.5L taxable capital gain.

Dear income tax department, applying a deduction from taxable income to tax free income makes no sense. It will not matter in ordinary circumstances. However, it can result in a significant reduction of taxable capital gains.

The formula used for calculating taxable capital gain is

If (total-income -2.5L - total-deductions) > 2.5 Lakh

Taxable Capital Gain = Reported Capital Gain

Else

Taxable Capital Gain = (Total-Capital-Gain-Reported) + (total-income -2.5L - total-deductions)

Now, when total income  = total deductions, a maximum deduction of 2.5L is possible from the reported capital gains.

When total income = 2.5L, the total deductions can be deducted from the reported capital gains.

I believe this is due to an incorrect double deduction when income < 2.5L

(total-income  2.5L - total-deductions).

Anyway, who cares what I think anyway.

The title says when and how capital gains tax can be reduced. I have discussed the when.  The how,  legally rare as it is, should be self-evident.

Note: I have expressed an opinion about an existing rule. I am sure most of you will disagree. If the above scenario can be interpreted in a different manner, please disucss below.

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21 thoughts on “When and How Capital Gains Tax Can be Reduced

  1. Abhishek Singh

    Hi Pattu,

    Nice article.

    It is very difficult to have 80C deductions when the income is around 2.5 to 3 Lakhs as merely running expenses for a family or even a single earner would come around that much and hence deductions make no sense.

    A small correction:

    Taxable Capital Gain = (Total-Capital-Gain-Reported) + (total-income -2.5L - total-deductions)

    It should be minus instead of plus as plus would increase the reported capital gain which can't be.

    Reply
    1. freefincal

      1) I think I had made enough references to the fact that this reduction is rare.
      2) Reg the formula, please see the If/Else condition.

      Reply
  2. cvan

    Sir, are you questioning the income tax law / act itself or are you pointing out a flaw in their calculation that does not conform to the income tax act?

    Reply
    1. freefincal

      A flaw in the calculation. A tax deduction is for reducing taxable income. To apply a tax deduction to tax-free income is flawed. In normal circumstances, it will not matter, but when there are taxable capital gains, it results in a significant tax deduction, which imo is a flaw.

      Reply
  3. tbells

    Sir, Can't one look at it as income from salary + income from capital gains and then apply standard deduction and after that 80c. The result will be the same. In Example 4, net income can be thought of as 4 lakhs and after standard deduction and 80 c, taxable amount is 0.5 lakhs. If we look at it that way, then there is no double counting. Or am I missing something?
    Vandhana

    Reply
    1. freefincal

      Awesome! That is exactly what they are should be doing. There is one problem (which I think is the equivalent of what I have described when we see things your way).

      Chapter 6-A deductions are from the gross income (in this case salary_income + capital_gains). If this is rigorously true then

      suppose my salary is 1L, capital gains = 5L, 80C = 1.5L

      Then gross income - deductions = 6L - 1.5 = 4.5L
      Out of this 2.5L is tax free and taxable capital gain should be 2L only.

      However, the IT dep limits 80C to salary income (it is less than 1.5L) and not gross income.
      So for the above example, only 1L is counted as 80C.

      Making the taxable capital gain 2.5L.

      Either way, there is an issue.

      Reply
  4. Kushal

    If you assume that the intent of IT dept is to give a benefit of 2.5L only, but also a bonus benefit if you invest in longer dated instruments (under 80C), then all the confusion goes away right? Rather than double counting i'd look it as incentive to invest long term (or lend to govt and most 80C instruments end up lending to govt right?)

    Reply
    1. freefincal

      Then they should be incentivising it right by linking the 80C limit to gross income and not salary income.

      Reply
    1. freefincal

      Yes. When the salary income is higher than the tax free limit, the CG income is taxed at flat rates. When salary income is zero or less than the tax-free limit, a sum equal to the room in the tax free limit can be deducted from the reported CG. The remaining CG (in any) will be taxed at the flat rate.

      In this post when I say income I am referring to that which is subject to tax slabs.

      Reply
  5. sajeev

    Hi Pattu,

    Nice article. Thanks for sharing.

    One question about which ITR forms to be filled up in the case of being a salaried employee...

    I am a salaried employee at a private org, and I recently sold my apartment. The apartment was sold 11 years after its registration.

    Which ITR should I be using for filing my taxes?

    Thanks,
    Warmest Regards, Sajeev

    Reply
  6. cvan

    Then, sir, I do have some counter arguments.

    I think your opinion is based your statement "A deduction from taxable income is applied to tax free income", as you 'boldly' pointed out. This is factually correct, adheres to the laws of income tax and the term 'tax free income' is indeed broadly used but your interpretation of it may make your reader think there is a flaw in calculation of it.

    ALL our income are liable to tax. That's why during tax filing we calculate 'gross total income' which happens to include all 5 heads of income including capital gains. Tax is calculated on 'net total income' after applying deductions and expenses to some of those income (just like you would have done for a corporate income). I repeat, our tax liability is based on our 'net total income'.

    Now, in our progressive taxation system we happen to have a tax bracket that has 0% as tax rate. (US does not have it for ordinary income but they have it for long term CG). You can call that bracket "tax free income" but again there is a tax rate difference between other brackets, then are you calling the rate difference between two brackets tax free income?

    For example, tax between 2.5 to 5 lakhs income is 12,500. If you had applied a tax rate of 20% (which is the rate between 5 to 10), you should have paid 50k. Does it mean 1,87,500 (2,50,000 - 12,500 X 100 / 20) is tax free for some reason? Just replace 12,500 with 0 for income till 2.5 lakh then probably it will be clear what I mean.

    As far as applying 80c deduction to capital gain too I guess is a topic for another article.

    Reply
    1. freefincal

      I am afraid I am unable to spot the counter in your arguments. Please also refer to the comment by tbelss and my response.

      Reply
  7. cvan

    Sir, the counter argument is, as a tax payer if you have invested in 80c from your ordinary income (REGARDLESS of that income is in tax free bracket or not), you should get a deduction. It should not matter whether that ordinary income was below or above 2.5 lakh.

    Since tax is on 'net income' (nothing exclusive to India, that's what happens everywhere), you add your capital gain on top of reduced ordinary income and find out which tax bracket you are in and calculate the tax.

    And as I said whether any leftover 80c deduction should be applied to capital gain or not is a different discussion. Because there is a school of thought where investment that gave you the capital gain is assumed to be done from your ordinary income in the first place - on which you would have applied 80c deductions when that income was earned. (This refers to your response to tbells).

    So I feel your statement "The 1L is already tax-free income and it is deducting the 80C investment from it. This is similar to double-counting. A deduction from taxable income is applied to tax free income. Which I think is wrong." is not entirely correct - especially the double counting part. I think you consider 2.5 lakh as a deduction (correct me if I am wrong otherwise I am not sure what you are considering as double counting). 0% tax bracket of 2.5 lakh IS NOT a deduction, it is just a tax bracket and 80c investment IS the only deduction which you have applied only once in all your examples.

    Reply
    1. freefincal

      If this is your core argument: "you should get a deduction. It should not matter whether that ordinary income was below or above 2.5 lakh.", I have no further comment.

      A capital gain is distinctly different ( by law and logic) from the amount invested (which is already taxed with all applicable deductions).

      Reply

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