In a previous article, we highlighted the common mistake made by many while claiming capital gain exemption under Section 54 and Section 54F – Claiming Capital Gains Exemption? Watch Out for This Common Slip. In this article, we shall deep-dive into how much one should invest to claim capital gain tax exemption under Section 54 of the Income Tax Act, 1961.
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What is Section 54?
As you are aware by now, Section 54 provides an exemption if the ‘capital gains’ arising from the sale of residential property are invested in another residential property, subject to meeting certain conditions.
The amount of capital gains to be invested is the difference between the Sale Price and the Cost Price, as per the Income Tax Act. However, for property purchases made before 23rd July 2024 and transfers made on or after 23rd July 2024, the resident individual has the option to calculate capital gains with or without indexation. Indexation is adjusting the property’s cost price to account for inflation up to the date of sale. If one calculates the gain without inflation, the tax rate is 12.5% while if indexation is factored in, the tax rate is 20%. Education cess and surcharge, if applicable, are over and above this.
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Let us take an example to understand.
Mr. X has sold his residential property for Rs. 1 Crore in August 2024. This property was purchased for Rs. 25 Lakhs in August 2004. Based on the inflation index published by the Income Tax department, the index cost price for the property comes to Rs 80.31 Lakhs.
Now, Mr. X has an option to choose one of the two methods to calculate the capital gain amount and pay the capital gain tax.
| Option 1: Without Indexation | Option 2: With Indexation | |
| Sale Price | 1,00,00,000 | 1,00,00,000 |
| Cost / Indexed Cost Price | 25,00,000 | 80,30,973 |
| Capital Gain Amount | 75,00,000 | 19,69,027 |
| Tax Rate | 12.5% | 20.0% |
| Tax Liability | 9,37,500 | 3,93,805 |
As is evident, Option 2 is beneficial for Mr. X since the tax liability is less.
Where does the confusion arise?
Mr. X decides to take advantage of Section 54 by investing in another residential property. To avail the benefit, he needs to invest the ‘capital gain amount’. Now Mr. X is confused, which capital gain amount needs to be considered: Rs 75 Lakhs as shown in Option 1 or Rs. 19.69 Lakhs as shown in Option 2? Since Mr. X tax liability was calculated basis Option 2, he assumed that Rs. 19.69 Lakhs needed to be invested to claim the tax benefit.
However, he is wrong. As per the Income Tax Act, Option 1 and Option 2 are given only to calculate the tax liability and pay the tax accordingly. If one is planning to take exemption under section 54, the indexation benefit is not available, and the capital gain amount, as determined by Sale Price less Cost Price (as per Option 1) needs to be reinvested to claim tax benefits. In our example, Mr. X will have to invest Rs. 75 lakhs in another residential benefit, to avoid payment of Rs. 3.93 Lakhs as taxes!!
Key takeaways:
The readers should remember the following points:
- If one is going to pay the tax, they need to pay the tax, which is the lower of Option 1 and Option 2.
- If one is planning to take advantage of Section 54 and save tax, they need to calculate the amount to be invested as per Option 1 only.
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