Section 45 of Income Tax Act

• ULIP Taxation Update: The government proposes to include ULIPs with premiums exceeding 10% of the sum assured, along with those having annual premiums above ₹2.5 lakh, under the new tax rules.
• Change in Capital Asset Definition: Section 2(14) may be revised to clarify that securities held by investment funds under Section 115UB will be treated as capital assets.

Also Read: Old Vs New Tax Regime: Which is Better?

Section 45 of the Income Tax Act of 1961 outlines the rules for taxing capital gains, which are profits earned from selling or transferring a capital asset. These assets can include property, stocks, bonds and other investments. Under this section, any profit or gain made from the transfer of a capital asset is considered taxable income in the year the transfer occurs.

However, certain exemptions are available under specific sections, such as Sections 54, 54B and 54EC. These allow individuals to reduce or avoid paying taxes if the gains are reinvested in specific assets like residential property or government bonds.

Let us take an example to understand this better:

If you sell a house for a profit in 2023, the capital gain from that sale will be taxed in the financial year 2023-24. However, if you reinvest the gain in another residential property under Section 54, you may be eligible for a tax exemption on the capital gains.

Understanding the charging section of capital gain provisions is important for anyone transferring assets to ensure proper tax planning and minimise liabilities.

Also Read: Section 45 (5A) of the Indian Income Tax Act

Understanding key terms related to capital gains is essential for navigating Section 45 of the Income Tax Act. Below are some important concepts:

What are Capital Assets?

A capital asset refers to any property owned by an individual, regardless of its connection to their business or profession. This includes securities held by Foreign Institutional Investors (FIIs).

However, some items are excluded from the definition, such as stock-in-trade, personal effects (excluding valuable items like jewellery or paintings), agricultural land in rural areas and certain specified bonds.

Types of Capital Gains - Short-Term and Long-Term

• Short-Term Capital Gains (STCG): These gains result from selling a capital asset held for 36 months or less. However, for financial assets like listed shares and securities, the holding period is reduced to 12 months. For unlisted shares and immovable property, the holding period is less than 24 months.
• Long-Term Capital Gains (LTCG): These gains arise when a capital asset is sold after being held for more than 36 months. For listed shares and securities, the holding period must exceed 12 months, while for unlisted shares and immovable property, it must be more than 24 months.

How to Calculate Capital Gains

Capital gains are calculated based on the following components:

• Full Value of Consideration: The sale price or value received from the transfer of the asset.
• Cost of Acquisition: The original purchase price of the asset.
• Cost of Improvement: Expenses incurred in enhancing the asset.
• Expenditure on Transfer: Costs directly related to the transfer, such as legal or broker fees.

For STCG, the formula is: STCG = Full Value of Consideration − Cost of Acquisition − Cost of Improvement − Expenditure on Transfer.

For LTCG, indexed values are used to account for inflation: LTCG = Full Value of Consideration − Indexed Cost of Acquisition − Indexed Cost of Improvement − Expenditure on Transfer.

The Cost Inflation Index (CII) helps adjust the acquisition and improvement costs to reflect inflation over time, making the taxation of capital gains fairer.

The Income Tax Act provides several exemptions and reliefs under Section 45 to help taxpayers reduce their capital gains tax liabilities. These provisions offer significant tax benefits if the gains from the sale of capital assets are reinvested in specified assets within the given time frame. Below are some of the most important exemptions available under the law:

Section 54 – Exemption on Sale of Residential Property

Section 54 provides an exemption on capital gains arising from the sale of a residential property if the gains are reinvested in another residential property. To qualify for this exemption, the taxpayer must use the proceeds from the sale to purchase a new residential house within two years or construct a new one within three years. The exemption under Section 54 can be claimed only if the property being sold is a long-term capital asset.

For example, suppose a person sells their residential house and uses the profit to buy another house within the specified period. In that case, they can claim an exemption on the capital gains, thus lowering their tax burden.

Section 54F – Exemption on Sale of Non-Residential Property

Section 54F allows for an exemption on capital gains from the sale of any asset other than a residential house (such as commercial property, shares or land). However, the exemption is available only if the entire sale proceeds are invested in the purchase of a residential house within two years or the construction of one within three years. If only part of the proceeds is reinvested, the exemption under Section 54F will apply proportionally.

For example, if a taxpayer sells a plot of land and reinvests the money to buy a residential house, they can claim an exemption under Section 54F. However, the exemption will be proportional to the amount reinvested if the entire sale amount is not used to purchase the new house.

Section 54EC – Exemption on Sale of Capital Assets Through Investment in Bonds

Section 54EC offers an exemption on long-term capital gains if the amount is invested in specified bonds, such as those issued by the National Highways Authority of India (NHAI) or the Rural Electrification Corporation (REC). To avail of the exemption under Section 54EC, the taxpayer must invest the gains within six months of the sale of the asset, and the bonds must be held for a minimum of five years.

For example, if a person sells a commercial property and invests the gains in NHAI bonds within six months, they will not have to pay capital gains tax, provided they hold the bonds for the prescribed period.

Section 54B – Exemption on Sale of Agricultural Land

Section 54B provides relief for capital gains arising from the sale of agricultural land. If the profits from the sale of agricultural land are used to purchase another piece of agricultural land within two years, the gains will be exempt from tax. This exemption is available only if the land was used for agricultural purposes for at least two years before the sale.

For example, suppose a farmer sells a piece of agricultural land and buys another one within two years. In that case, they can claim an exemption under Section 54B, provided the land was being used for agriculture before the sale.

Also Read: Long Term Capital Gain on Property

Section 45 of the Income Tax Act also covers specific scenarios related to capital gains, where different rules apply based on the nature of the transfer of the capital asset. Let us look at these special provisions in simple terms:

Compulsory Acquisition

When the government or any legal authority takes away a capital asset through compulsory acquisition, the capital gain from this process is taxed in the year the compensation (or part of it) is received.

This means that even if the transfer happened earlier, the tax will only be applied when the compensation money is paid. For example, if the government acquires a piece of land in 2022 but the payment is made in 2023, the capital gain will be taxed in 2023.

Capital Asset Converted into Stock-in-Trade

When a capital asset, like land or building, is converted into stock-in-trade for a business (like a builder converting land into a project), the capital gains are not taxed immediately. Instead, the gains are taxed when the stock-in-trade is eventually sold.

The fair market value of the asset on the date of conversion is considered for calculating capital gains. For instance, if you convert land into business stock in 2020 and sell it as a developed plot in 2023, capital gains will be calculated based on the land’s market value in 2020 and taxed in 2023.

Insurance Compensation for Destroyed Assets

Suppose a capital asset, like a building or factory, is destroyed due to fire, flood or other damage, and the owner receives insurance compensation for the loss. In that case, the capital gain is taxed in the year the compensation is received.

For example, if a factory is destroyed by fire in 2021 and the insurance company compensates the owner in 2022, the capital gain tax will apply in 2022.

Joint Development Agreements

In cases where a property owner enters into a joint development agreement with a developer (where the owner provides land and the developer builds on it), the capital gains are taxed when the project is completed or at least a part of it is certified as complete by the relevant authorities.

This means that tax is applied only when the project achieves a certain stage of completion, as defined in the agreement between the owner and developer.

Short-term capital gains (STCG) arise when a capital asset, such as shares, mutual funds or property, is sold within a short holding period, typically less than 36 months for most assets or 12 months in the case of equity shares and equity-oriented mutual funds.

The tax treatment of these gains varies based on the type of asset and whether a securities transaction tax (STT) is applicable.

Where STT is applicable

For transactions involving equity shares and equity-oriented mutual funds, where STT is paid, short-term capital gains are taxed at a flat rate of 15%. Depending on the taxpayer's income, a surcharge and education cess may also be applicable.

In all other cases

For other capital assets like property or non-equity investments, short-term capital gains are taxed according to the individual's income tax slab rate. This means the gains are added to the taxpayer's total income and taxed accordingly, which can range from 5% to 30%, depending on the income level.

Long-term capital gains (LTCG) arise when a capital asset, such as shares, mutual funds or property, is sold after a longer holding period - typically more than 36 months for most assets or more than 12 months for equity shares and equity-oriented mutual funds. The tax treatment for LTCG depends on whether the securities transaction tax (STT) is applicable.

Where STT is applicable

For equity shares and equity-oriented mutual funds, where STT is paid, long-term capital gains are taxed at a rate of 10%. However, gains up to ₹1,00,000 in a financial year are exempt under Section 112A, meaning only the amount exceeding ₹1,00,000 will be taxed. Additionally, a surcharge and education cess may apply, depending on the taxpayer's income.

In all other cases

For assets such as property or non-equity investments, long-term capital gains are taxed at a higher rate of 20%. The benefit of indexation, which adjusts the purchase price for inflation, can be availed, potentially lowering the taxable gains. A surcharge and education cess are also applicable in this case.

Failing to comply with the provisions of Section 45 of the Income Tax Act, which deals with the taxation of capital gains, can result in significant penalties. Taxpayers must ensure that they accurately report their capital gains and pay the correct amount of tax within the designated timeline.

Non-compliance not only attracts legal consequences but also adds unnecessary financial burdens in the form of penalties and interest.

Penalties for Non-Compliance

The Income Tax Department has stringent measures in place to detect any discrepancies or attempts to evade taxes. If a taxpayer fails to report capital gains accurately or delays paying the tax owed, they may face substantial penalties.

Interest on unpaid taxes will also accumulate, increasing the taxpayer's financial impact. In severe cases, persistent non-compliance can even lead to prosecution and legal proceedings.

For example, if a person sells a property and does not declare the capital gains from that sale in their income tax return, they might face a penalty that could be a percentage of the undeclared amount. Additionally, interest will be charged on the unpaid tax amount, further adding to the taxpayer's liability.

Importance of Accurate Documentation

One key step to ensuring compliance with Section 45 is maintaining accurate records and documentation. Taxpayers should keep all relevant documents, such as purchase invoices, receipts for any improvements made to the asset and sale agreements.

These records are crucial for calculating the correct amount of capital gains and for justifying any exemptions or deductions claimed under other sections, like Section 54.

For instance, if someone has made improvements to their property before selling it, the cost of those improvements can be deducted from the total capital gains. However, to claim this deduction, proper receipts and documentation must be submitted to the tax authorities. Failing to maintain these records could result in overpayment of taxes or penalties for incorrect filing.

Seeking Professional Guidance

Calculating capital gains can often be complex, particularly with the various exemptions available under the law. For many taxpayers, navigating these complexities without professional help can lead to mistakes and non-compliance. This is why it is advisable to seek guidance from a tax consultant or chartered accountant, who can ensure that all legal requirements are met.

Professional advice is especially important when dealing with multiple capital assets, joint development agreements or complex exemptions. Tax experts can help minimise tax liabilities through strategic planning, such as reinvesting capital gains into eligible assets to claim exemptions.

Investment Planning for Compliance

Strategic investment planning can help taxpayers optimise their tax liabilities under Section 45. For example, by timing the sale of an asset to fall under long-term capital gains (LTCG) tax rates, taxpayers can significantly reduce the tax they owe compared to short-term capital gains tax rates.

Additionally, reinvesting capital gains into specified assets, like a new residential property or certain bonds, can qualify the taxpayer for exemptions under sections like 54 or 54EC. By planning investments, taxpayers can not only ensure compliance with the law but also reduce their overall tax burden. This approach helps taxpayers avoid non-compliance issues while optimising their financial returns.

Maintaining Proper Documentation

Keeping detailed records is essential for accurately calculating and reporting capital gains. Ensure you have all necessary documents related to your capital assets, such as purchase invoices, receipts for any improvements made and sale agreements. These records help determine the cost of acquisition, improvements and the final sale price, making tax filing easier and reducing the risk of disputes.

Seeking Professional Advice

Understanding capital gains taxation can be complex due to various tax rules and exemptions. Consulting a chartered accountant or tax professional can provide clarity and ensure compliance with tax laws. Experts can guide you on available deductions, exemptions and the correct method of computation, helping you minimise tax liability while adhering to legal requirements.

Optimising Investment Planning

Smart investment planning plays a key role in managing capital gains tax. Timing the sale of assets can impact whether they qualify for short-term or long-term capital gains tax rates, which can significantly affect tax liability.

Also, reinvesting the proceeds in specified assets, such as residential properties or government bonds, can help in availing tax exemptions. By planning investments wisely, you can reduce taxable gains and maximise savings.

Capital gains are an essential part of financial planning, influencing decisions beyond just taxation. When you sell an asset like property or stocks, the profits are taxed as capital gains. However, with smart planning, you can use these gains to strengthen your financial security, including investing in a medical insurance policy.

The best health insurance policy not only protects you against rising healthcare expenses but also provides tax benefits under Section 80D of the Income Tax Act. The premiums you pay for health insurance can be deducted from your taxable income, helping you save on taxes while ensuring access to quality medical care.

This makes investing in medical insurance a strategic move, especially when managing capital gains. By aligning your capital gains with health insurance investments, you can create a balanced approach to financial security. If you have substantial long-term capital gains, allocating a portion towards health insurance premiums can provide dual benefits—tax savings and financial protection against unforeseen medical emergencies.

At TATA AIG, we offer comprehensive health insurance plans designed to fit your needs, providing cashless treatments, extensive coverage, and tax advantages. Take a step towards a financially secure future by choosing the best health insurance policy that safeguards both your health and your wealth.