Limit Section 54 benefit to curb money laundering

Section 54 tax exemption should not be available if the taxpayer already owns two or more properties on the date of sale of property

Recently, there was a news report about a corrupt bureaucrat who was caught with currency notes running into crores and papers showing ownership of 17 flats. There is a close linkage between the footage showing a room full of currency notes and visuals of plush flats the corrupt bureaucrat owns.  

A piece by economist Vivek Kaul highlighted how changes in tax laws have had a mild dampening impact on the activities of such real estate “investors”. In my view, the impact has been mild because of the continuation of Section 54 of the Income-Tax (I-T) Act in its current form. It completely exempts the long-term capital gains from tax if the capital gains are invested in another residential flat. There are no restrictions on the number of residential flats for which this exemption can be claimed.    

Here's an example of how a person converts his black money into white by misusing Section 54. 

Suppose Property A has a market value of Rs 100 lakh and a ready reckoner value (or circle rate) of Rs 60 lakh. The person seeking to launder his black money buys this property at Rs 100 lakh. On record he shows the purchase price as Rs 60 lakh (the ready reckoner value). The balance Rs 40 lakh is paid in cash using his black money. After two years, if the property doesn’t appreciate, it is sold in white for Rs 100 lakh, resulting in a paper capital gain of Rs 40 lakh. This Rs 40 lakh is reinvested in Property B.

Assuming prices remain stagnant, Property B is sold after three years at Rs 40 lakh. No long-term capital gains tax is paid. Thus, the black Rs 40 lakh becomes pristine white money without any cost after five years.

Demand from such “investors” makes homes unaffordable for those who genuinely need them.  

At the same time, Section 54 exemption enables middle-class folks to upgrade their houses, or buy more than one property. The government needs to balance their needs while trying to curb money laundering. Fortunately, it has a blueprint for doing both in the provisions of Section 54F.

Section 54F deals with long-term capital gains tax exemption on the sale of assets other than residential property (covered by Section 54). A few crucial differences provide effective limits on this exemption. First, the exemption is not available if the taxpayer already owns two or more properties on the date of sale of property. Second, the exemption is withdrawn if the taxpayer buys another property during the next three years. Third, the taxpayer has to reinvest the entire sales proceeds rather than just the capital gain.  

If similar restrictions were imposed in Section 54, our example will play out as follows: Property A is purchased at Rs 100 lakh (agreement value Rs 60 lakh). When sold after two years, tax exemption won’t be available if the taxpayer owns more than one other property, besides Property A. This restriction will eliminate the likes of the bureaucrat owning 17 flats. Second, Property B will have to cost Rs 100 lakh (not Rs 40 lakh) to claim full exemption. Third, if the taxpayer buys any property other than Property B over the next three years, the exemption will be withdrawn. Game, set and match against money launderers.  

Section 54 was part of the I-T Act enacted in 1961—a time when few people bought houses. Tax exemptions were needed to tempt them into buying a residential house. Truth be told, this tax exemption has turned into a loophole that facilitates money laundering. Restrictions should be imposed so that only the deserving benefit from it.

The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor; Twitter: @harshroongta