The ifs and buts of capital gains

The law does not allow clubbing of Section 54 exemptions for reinvestment purposes.

Having sold an apartment, Mukund Naik preferred to reinvest the money got from the sale, into buying another one. This would ensure that he would get the benefit of Section 54 of the Income Tax Act. It exempts one from capital gains tax incurred on the sale of a residential property held for at least three years. The condition though, is that the person invests, an equivalent amount in another home property. However, let us consider possible variations while re-investing the funds and the tax implications of doing so.

RE-INVESTING FUNDS
Lets suppose a scenario where the tax payer sells two of his house properties. He now wants to invest the long-term capital gains from the sale of both properties in the third flat? In other words, does the law under Section 54, allow a tax payer to club two exemptions for reinvestment in one property.
 

THE RULE

• No restrictions on the number of property sold to claim exemption 
• Only one property can be bought against each claim 

THE IMPACT 

• No exemption on second home, if you purchase two or more properties from capital gains from sale of one
• If re-invested amount is lower than the incurred capital gains, the balance amount would be taxable.

Now lets consider another scenario. Here, suppose the taxpayer re-invests the capital gains in two properties. However, the cumulative investment amount is more than the total capital gains arising out of the sale of the original two properties. In such a situation, will the exemption still apply? Luckily for taxpayers, the Income tax authorities have given clear rulings for both these possibilities.

The Income Tax Appellate Tribunal, Mumbai, answered these questions while dealing with the case of Rajesh Keshav Pillai. Lets go through the background in the case. Pillai had sold two flats, in the same building, during 2005. And his capital gain was Rs 88 lakh in respect of Flat A and Rs 85 lakh for Flat B. He then invested the capital gains in two other flats, at a cost of Rs 81 lakh (Flat C) and Rs 95 lakh (Flat D), respectively. Thus, cumulatively the cost of flats purchased (Rs 1.76 crore) was more than the total capital gains of Rs 1.73 crore. He, then went ahead and claimed the entire capital gains as exempt under the provisions of Section 54.

THE RULING
The tax officer denied the exemption, saying Section 54 was available only for sale of one house property. It had, he noted, used the word ‘a’ property, not ‘any’ property. In other words, the intention was to allow exemption only in respect of one house. So, he allowed exemption of capital gains for Flat A by taking into account the investment into Flat D. The entire capital gains for Flat B were held to be taxable. A dissatisfied Pillai appealed to the Income Tax Appellate Tribunal.

No and yes, said the Tribunal. Section 54 did not restrict the number of houses that could be sold to claim exemption. As long as the properties sold were long-term capital assets, the exemption would be available for not just two but more houses sold. With, it added, this catch: The section did restrict, to a single one, the number of houses which could be bought to claim the exemption.

If more than one house was sold, the exemption would be available in relation to each sale and the corresponding investment in a new house. Or, in Pillai’s case, the investment in Flat D could be claimed against the capital gain for Flat A, while the investment in Flat C could be claimed against the gain of Flat B. As the amount invested in Flat C was lower than the capital gain from Flat B, the balance amount would be taxable as long-term capital gains. The Tribunal refused to admit Pillai's’ plea for aggregating the capital gains for both houses and exempting the entire gain against the total investment made in two flats.

A corollary to this is whether the capital gain from the sale of a single house could be invested in more than one to claim the Section 54 exemption. For this, turn to the case of Sushila Jhaveri. Where, it was decided that exemption from capital gains applies only in respect of investment in one residential house. Thus, if you purchase two more house properties out of the capital gain from the sale of one, there’s no exemption for the second house.

The writer is a certified financial planner