Section 54 of Income Tax Act
Section 54 of Income Tax Act
Section 54 of the Income Tax Act provides tax exemptions on capital gains from the sale of residential property, provided the proceeds are reinvested in another residential property. This section is essential for homeowners, real estate investors and taxpayers who aim to minimise their tax liabilities upon selling property.
Understanding Sec 54 of the Income Tax Act can be especially beneficial for individuals planning to reinvest in property, as it helps make more informed financial decisions and benefit from potential tax relief. This guide offers a detailed overview of the nuances of the tax relief from capital gain Section 54 of the Income Tax Act offers to help you maximise your tax savings while also complying with tax regulations.
What is Section 54 of the Income Tax Act?
Section 54 of the Income Tax Act of 1961 offers a significant tax advantage to individuals and Hindu Undivided Families (HUFs) who sell their residential property. This section provides an exemption from long-term capital gains tax if the proceeds from the sale are reinvested in the purchase or construction of another residential property.
To qualify for the exemption, the new property must be purchased either within one year before or two years after the sale or constructed within three years from the date of sale.
Budget 2024 Updates for Section 54 of the Income Tax Act
The Union Budget of 2024 has introduced significant updates that impact the capital gains and in turn, affect taxpayers who intend to utilise Section 54 of the Income Tax Act for tax exemptions on gains from the sale of residential property. Here are the details of the introduced revisions:
-Reduced Holding Period
The minimum holding period for a residential property to qualify for deduction under 54 has been reduced from three years to two years. This change provides more flexibility to taxpayers, allowing them to reinvest their capital gains more quickly.
-Expansion in Scope of Eligible Properties
The definition of ‘residential property’ has been broadened to include certain categories of properties that were previously excluded. This expansion offers more opportunities for taxpayers to utilise Section 54 of the Income Tax Act to their advantage.
-Updates in Tax Rates on Long-term Capital Gains
The taxation rate for long-term capital gain has been lowered to a flat 12.5% for all asset classes. One of the major changes introduced was the removal of the indexation benefit for most assets.
This benefit, which allowed taxpayers to adjust the purchase cost for inflation, is now withdrawn except for land and buildings acquired before July 23, 2024, by resident individuals and Hindu Undivided Families (HUFs).
The exemption limit for long-term capital gain has been increased from ₹1 Lakh to ₹1.25 Lakh per year.
-Updates in Tax Rates on Short-term Capital Gains
The short-term capital gain tax rate on equity shares, units of business trusts and units of equity-oriented funds listed in India has been increased from 15% to 20%.
The short-term capital gain tax rate on other non-financial assets, including unlisted bonds, debentures, debt mutual funds and market-linked debentures, will now be taxed at the applicable income tax slab rates, irrespective of the holding period.
Exemptions Under Section 54 of the Income Tax Act
-Eligible Taxpayers and Assets
The exemption under Section 54 of the Income Tax Act applies only to individuals and HUFs. Other entities, including partnership firms, LLPs, companies and associations, are not eligible to claim this exemption. The asset sold must be a residential house and classified as a long-term capital asset, meaning it was held for more than two years.
Additionally, the property sold should generate income categorised as ‘Income from House Property’. Commercial properties and properties used for business purposes do not qualify for the Sec 54 exemption. Vacant plots of land also do not qualify for the capital gain exemption on sale of land unless they are sold together with a residential house.
-Conditions for Reinvestment
To claim the exemption under Sec 54, the taxpayer must reinvest the capital gains in a new residential property in India. The reinvestment options are as follows:
-Purchase: The new property must be purchased either one year before or two years after the sale of the original property.
-Construction: If constructing a property, the construction must be completed within three years from the date of sale.
-Compulsory Acquisitions: In cases of compulsory acquisition, the timeline begins from the date of receipt of compensation.
If these conditions are not met or if the reinvestment is not completed before the due date for filing the income tax return, the capital gains must be deposited in a capital gains account scheme to claim the Sec 54 exemption.
-Limits on Sec 54 Exemption
From April 1, 2023, the maximum exemption under Sec 54 is limited to ₹10 crore. There was no threshold limit for transactions before this date. Additionally, starting from the Assessment year 2020:** 2021, taxpayers can claim an exemption for the purchase of up to two residential houses, provided the capital gains do not exceed ₹2 crore. This dual-property exemption is only available once in a taxpayer’s lifetime.
The amount of exemption under Sec 54 is required to be the lower of:
- Long-term capital gains arising from the sale of residential property.
OR
- The investment made in purchasing or constructing a new residential property.
For example:
Let us assume that Person A sells their residential property for ₹75,00,000 and invests ₹30,00,000 in purchasing another residential property.
| Parameters | Amount |
|---|---|
| Capital gain on the transfer of residential property | ₹75,00,000 |
| Less: Investment that has been made in the residential house property | ₹30,00,000 |
| Remaining Balance:** Capital Gains | ₹45,00,000 |
Types of Properties Eligible for Sec 54 Exemption
Only residential properties qualify as eligible assets for exemption under Sec 54. These can include apartments, independent houses or other dwelling units used for residential purposes. The property should be owned and utilised by the seller for residential purposes. Commercial properties or vacant plots of land, unless sold with a residential house, are not eligible for this exemption.
Provisions Related to Transfer of Property After Claiming Exemption Under Sec 54
If the new property acquired to claim a Sec 54 exemption is sold within three years, the exemption previously granted is effectively revoked, which impacts the capital gains calculation. When the cost of the new property is less than the capital gains of the original sale, the entire sale consideration becomes taxable as capital gains.
On the other hand, if the newly acquired property’s cost exceeds the capital gains from the original sale, the exemption is reversed and the adjusted cost is reduced by the amount of the previous exemption, which increases the taxable gains on the resale.
Here are a few examples to offer a better understanding:
-Case 1: Where the Cost of the New House is Less than the Capital Gains on the Original Sale
In this situation when the new house is sold within three years, the entire sale consideration of the new house is treated as taxable capital gains, as its cost of acquisition is considered NIL for taxation purposes. This results in an indirect increase in taxable gains.
For example:
Let us assume Person X sold their residential property in May 2010, which resulted in a capital gain of ₹50,00,000. In July 2010, they reinvested ₹30,00,000 in a new residential property with the intent to claim an exemption under Sec 54. However, Person X sold this newly acquired property in March 2012 for ₹60,00,000, which is within the three-year holding period.
In this case, here is how the capital gains for Person X would be computed:
Financial Year 2010 - 2011 (Original Property Sold in May 2010)
Parameters
Capital gain on the transfer of original residential property
Less: Investment that has been made in the new residential house property
Remaining Balance - Taxable Capital Gains
| Parameters | Amount |
|---|---|
| Capital gain on the transfer of original residential property | ₹50,00,000 |
| Less: Investment that has been made in the new residential house property | ₹30,00,000 |
| Remaining Balance - Taxable Capital Gains | ₹20,00,000 |
Financial Year 2011 - 2012 (New Property Sold in March 2012)
Since the new property was sold within three years, its cost of acquisition is taken as NIL, which makes the entire sale value taxable as capital gains.
| Parameters | Amount |
|---|---|
| Sale consideration of new residential property | ₹60,00,000 |
| Less: Cost of acquisition | NIL |
| Remaining Balance - Taxable Capital Gains | ₹60,00,000 |
In this case, Person X would have their taxable capital gains of ₹60,00,000 in the Financial Year 2011 - 2012 due to the reversal of the exemption that was claimed previously. If the property had been sold after three years, Person X would have been able to deduct the cost of acquisitions, i.e. ₹30,00,000 and reduce the taxable capital gains.
-Case 2: Where the Cost of the New House is More than the Capital Gains on the Original Sale
If the cost of the new property is higher than the capital gains on the original sale, the entire capital gains amount will typically be exempted as it is reinvested. However, if the newly acquired property is sold within three years, the calculation for the cost of acquisition will deduct the exempted capital gains from the original purchase cost, increasing the taxable gains.
For example:
Let us assume Person Y sold their residential property in July 2010, which resulted in a capital gain of ₹35,00,000. He purchased a new residential property in December 2010 for ₹55,00,000 and claimed an exemption under Sec 54. In August 2012, Person Y sold their new property for ₹70,00,000 within the three-year holding period.
Financial Year 2010 - 2011 (Original Property Sold in July 2010)
| Parameters | Amount |
|---|---|
| Capital gain on the transfer of original residential property | ₹35,00,000 |
| Less: Investment that has been made in the new residential | ₹55,00,000 |
| house property | |
| Remaining Balance - Taxable Capital Gains | NIL |
Since Person Y reinvested an amount higher than their capital gains, their taxable capital gains for the Financial Year 2010 - 2011 are NIL.
Financial Year 2011 - 2012 (New Property Sold in August 2012)
Because the new property was sold within three years, the cost of acquisition will be recalculated by deducting the capital gains exemption that was previously claimed.
Working Note: Computation of Cost of Acquisition
| Parameters | Amount |
|---|---|
| Original cost of acquisition of new property | ₹55,00,000 |
| Less: Capital gains exemption claimed earlier | ₹35,00,000 |
| Adjusted Cost of Acquisition | ₹20,00,000 |
With the adjusted cost of acquisition, the taxable capital gains in the Financial Year 2011 - 2012 would be computed as follows:
| Parameters | Amount |
|---|---|
| Sale consideration of new residential property | ₹70,00,000 |
| Less: Adjusted cost of acquisition | ₹20,00,000 |
| Remaining Balance - Taxable Capital Gains | ₹50,00,000 |
In this example, Person Y would have taxable capital gains of ₹50,00,000 in the Financial Year 2011 - 2012. If they had retained the new property for more than three years, the full cost of acquisition, i.e. ₹55,00,000, would have been deductible, which would significantly lower their taxable gains.
Difference Between Section 54 F and Section 54 of the Income Tax Act
| Parameters | Section 54 | Section 54 F |
|---|---|---|
| Applicability | Sec 54 exemptions are applicable on long-term capital gains from the sale of a residential property. | Section 54 F exemptions are applicable on long-term capital gains from the sale of any asset other than a residential property. |
| Investment Requirement | To claim a full exemption under Sec 54, capital gains need to be reinvested entirely. | To claim a full exemption under Section 54 F, net sale proceeds need to be reinvested entirely. |
| Partial Investment | If the capital gains are not entirely reinvested, the uninvested portion is taxed as long-term capital gain. | If the sales proceeds are not entirely reinvested, the exemption is allowed proportionately under this calculation: |
| Ownership of Residential Property | There are no restrictions on owning multiple residential properties at the time of sale. | For deductions under this section, a taxpayer should not own more than one residential house at the time of sale of the original asset. |
| Reversal of Exemption | Sec 54 exemption is reversed if the new property is sold within three years from purchase. | Exemption under this section is reversed if the new property is sold within three years of purchase or construction or if another residential property is purchased within two years or constructed within three years from the sale of the original asset. |
| Investment in Multiple Properties | Under this section, for capital gains up to ₹2 Crores, a one-in-a-lifetime exemption is allowed for investment in up to two residential properties. | Under this section, there is no provision for investment in multiple properties. The exemption applies to only one property. |
Conclusion
Section 54 of the Income Tax Act offers significant tax benefits to individuals and HUFs who reinvest capital gains from the sale of residential property into a new home. The recent updates introduced under Budget 2024 have further enhanced this provision by relaxing holding period requirements, expanding the eligibility criteria for properties and adjusting tax rates.
By strategically utilising the deduction under 54, taxpayers can optimise their tax savings, make informed decisions and ensure compliance with tax regulations.
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