Income tax is an unavoidable drain and hence an integral component of investment strategy. Long term capital gain tax or LTCG tax generally is the lowest tax rate applied to Investment returns. Hence, knowing the applicability and provisions can greatly impact where you park your money and how much you get to keep out of the returns that it generates.

What is Capital Gain?

Any profit or loss from the sale of a capital asset is called capital gain or capital loss respectively. This gain or loss is categorized as income and thus is subject to income tax. Gifts, inheritance, etc are not subject to capital gain tax unless they are sold, at which time the tax is applicable.

The income tax is to be paid in the year in which the sale takes place – irrespective of the timing of consideration (cash) received. This has an important bearing from the perspective of timing the sale both inter-year and intra-year. For example, you might want to book profits in a year of losses to offset tax liability. Additionally, you might not want to do a large property sale at the end of the year when there might be chances of tax outflow preceding the actual cash inflow from the sale.

What are capital assets?

Land, building, house, jewellery, shares, trademarks, bonds, etc are some of the examples of capital assets. Some of these items which may be used for personal reasons or business / professional reasons may not be classified as capital assets. For example: a house might be capital asset for a normal middle class person, however for a builder or a renovation company a house might be classified as inventory. Some other exceptions are agricultural land in rural area and some specific series of bonds & certificates issued by the government.

Types of Capital Gain taxes

Capital gain taxes are classified on the basis of investment holding period and different investment options have different holding period thresholds after which the investment return classifies to be long term capital gain and therefore the long term capital gain taxes have to be paid instead of the short term capital gain taxes which have generally higher rates. Hence, to improve post-tax returns, paying long term capital gain tax is generally preferable.

Long term capital gain tax – Time requirements

As mentioned above, different types of investment options have different eligibility criteria for qualifying for long term capital gain tax.

The following have 12 months minimum duration:

Equity or preference shares in a company listed on a recognized stock exchange in India
Units of equity oriented mutual fund, whether quoted or not
Securities (like debentures, bonds, govt securities, etc.) listed on a recognized stock exchange in India
Units of UTI
Zero-coupon bonds

The following have 24 months minimum duration:

Land, building and house property
Shares of Unlisted company

The following have 36 months minimum duration:

Debt Funds
All other movable property (gold, jewellery, corporate fixed deposits, etc)

In case the asset is received as a gift, inheritance, or through will or succession, etc, then the period of holding will also include the period that the previous owner held the asset. In case of bonus shares or rights issue, the period starts from the date of allotment.

Long term capital gain tax – Rates & comparison with short term rates

As mentioned above, the long-term capital gain tax rates are generally lower than the short-term ones. Hence it is imperative that the investment options are chosen to keep the impact of rates in mind. To have that comparison it is important to know what are the rates that are applicable to short-term and long-term capital gains.

Long term capital gain tax rate

10% over 1 lac of income is applicable on Investment in Equity or preference shares of a company listed on a recognized stock exchange of India & Units of equity-oriented mutual funds.

20% with indexation benefit is applicable on all other capital investments.

Hence it can be seen that equity investments enjoy the best rates in long-term tax rates. However, until recently the long-term tax rates were 0, and 10% was enforced only recently (applicable after 31st Jan 2018). But this meant that people who were holding stocks for a long period and whose stock prices had risen considerably would now have to give a large tax. To correct that, the government introduced a grandfathering clause in the computation.

Grandfathering clause according to Wikipedia basically means that an old rule still applies to some section of people or situations whereas a new rule applies to others. Those who are exempt from the new rule are said to have been grandfathered in.

Similarly, in this case, provisions are made to affect 0 LTCG tax till 31st Jan 2018 and 10% post that.

Short term capital gain tax rate

Short term capital gain tax rate is simple:

For investments where Securities transaction tax (STT) is payable, 15% is applicable otherwise the marginal tax slab rate is applicable, i.e. income gets added to the total income and regular tax computation is used to arrive at total tax liability.

Do you know the highest marginal tax rate?

It is 42.74%!!! – applicable above 5cr (incl surcharge and cess).

So if you compare the highest and lowest tax rates for the super-rich – 10% (excl cess etc) in equities for the long term and 42.74% in some other forms of investments – which investment option do you think people will choose?

Long term capital gain tax LTCG tax vs STCG tax
Long term capital gain tax LTCG tax vs STCG tax

Calculation of LTCG

As mentioned above –

For equity, let’s say that you have a 1.5Lakh return in a financial year, then after the 1 lakh relaxation, you will have to pay 10% on 50,000 = Rs 5,000.

For investments where indexation is required the cost has to be indexed to the present period and then the profit has to be calculated. The indexation has to be done using the table of cost inflation index (CII) which the government notifies. It can be seen here.

Indexed cost = actual cost * CII of sale year / CII of purchase year

For example: If you bought in 2005-06 for 15000 (CII = 117) and sold it in 2019-20 (CII = 289) then the indexed cost = 15000*289/117 = Rs 37,051.

So if it was sold for 50,000 then the LTCG would be Rs 12,949 and not Rs 35,000.

If there are costs associated with the transfer, or with the improvement of an asset (like a house), those indexed costs can also be deducted to get the profit. CII would have to be taken for the year when the expense was done.

LTCG Calculations
LTCG Calculations

Calculation of STCG

For the short term, indexation is not required, and thus the sale value less the purchase value less the transfer and improvement cost is the short term capital gain.

Tax Exemption and saving on Capital gains

There are certain provisions under which you can be exempted to pay income tax on capital gains. These come into play when the proceeds from sales (either full or the profit) are used in a specified way. Full details will follow soon in an upcoming blog.

Final Words

Tax is an integral component of investment strategy. As we saw that income may be taxed at 10% and 42% when received from different sources or if it is invested for a different time period. An HNI with a large income would probably want to go the 10% route and not want the slab based rate, however, someone with a low income would want to get the slab rate as that might be 0!

Thus, choosing a tax-efficient strategy is imperative as it has a large impact on wealth creation goals. Let me know in the comments what do you think and how do you optimize tax on your investments.

Recommended Read: Investment: What Is Important – Risk Or Return? What Else?