Lot of confusion prevails over capital gains taxation. There are various asset classes like equity, debt, gold & real estate where the gains are taxed differently. This happens due to the differential treatment of holding period of your investments while deriving the gains. Ideally when you make any investment you do it according to the time horizon of your goals and risk appetite. But taxation is one of the important consideration as any tax liability on your gains impact your returns from the investment.Thus, it’s important to have awareness on how your earnings will be taxed so that you know how much you are going to receive.
The capital gains are classified into long term or short term based on the holding period of investment. For e.g. in real estate, if you have held the asset for more than 3 years it is treated as long term. Contrary to this in equities investment for more than a year is treated as long term. While long term investments are taxed at 10 or 20% (with or without indexation), short term gains are generally added to your income. But budget 2014 has brought some changes to the definition of holding period in some instruments and has altered the taxation benefit.
Given below are calculations on how long term and short term capital gains are derived and how indexation benefit help in reducing your taxability:
- Long term Capital Gains
A long term capital gain arises when you hold any asset for a defined period. This period ranges from one year to three year across different asset classes. The table below shows the holding period for long term gains in various asset classes and the applicable tax rate post Union Budget 2014-
As can be inferred from the above chart, equities enjoy zero taxability on long term capital gains while in real estate or physical gold investment you have to pay a flat rate. the biggest change has been on non-equity mutual funds where the holding period has now been increased to three year and a flat tax rate of 20%. Due to these variations the post-tax returns from these asset classes can vary substantially. There are provisions in income tax to reduce LTCG through indexation or save LTCG tax from some of these instruments by investing it in other alternatives.
Indexation Benefit: Inflation constantly erodes real value of money through rise in prices. Due to this even if your investment have risen four times the purchasing power of money will have went down 50% from the time you made investment. To reduce the impact of inflation on your investment, indexation benefit is provided in calculating long term capital gains. Through this benefit you can adjust your capital gains from inflation by applying an appropriate factor from cost inflation index to the original units.
Here is how indexation benefits works:
Cost of purchasing a property in April 2007- Rs 3500000
Cost of selling the property in May 2011 – Rs 5000000
Inflation Index- 2007-2008 – 551
2011-2012 – 785
Indexed Purchase cost- 3500000*785/551= Rs 4986388
Long Term Capital Gains= 5000000-4986388 = Rs 13612*
Tax on LTCG= 13612*20%= Rs 2722
Education Cess= 2722*3% = Rs 82
Total Tax on LTCG = Rs 2804
*The non- indexed gain would have been Rs 15 lakh
Thus, the indexation benefit reduces the tax liability substantially which otherwise would have been a huge payout for any investor.
- Short Term Capital Gains
Investments in any asset class if held for a very short period is taxed as short term capital gains. Except equity, short term gains from other assets is included in investor’s income and taxed at slab rate. The data below highlights the taxation structure in case of short term capital gains post Union Budget 2014-
This is how short term capital gains are calculated:
Cost of Equity Mutual Funds units bought in 2011- Rs 100000
Price of same units sold after 6 months – Rs 120000
Short Term capital Gains – Rs 20000
Tax Applicable- 20000*15%= Rs 3000
Education Cess – 3000*3%=Rs 90
Total Tax payable= Rs 3090
There is no benefit of indexation to reduce short term capital gains tax liability.
- Set Off Losses
There are many instances when you might have incur losses from your investments and would have held capital gains also. Income tax provisions allow you to set off your losses from the gains you have earned. A long term capital loss can be set off only from a long term capital gains but a short term capital loss can be set off either with long term or short term capital gains. This provision of income tax also helps in reducing your capital gains if you are carrying losses from your income. However, you should consult a tax expert to derive the maximum benefit out of it.
With such complex capital gains tax structure, it’s wiser that you should first make yourself aware on the net returns i.e. post tax returns you will earn, whenever you intend to make any investment. Take assistance form an expert if you are not able to do it yourself. This will help in analyzing the amount of wealth creation you will create after paying your tax liabilities.
Do you look at post tax returns? Are you aware of changes being introduced?
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