This article has been authored by Bhavika Mittal, pursuing BA LLB from Shri Navalmal Firodia Law College, affiliated with Pune University, Pune. It provides a detailed insight into capital gains tax and briefly discusses related terms like capital asset, capital gain, and others. Moreover, the article talks about the taxation system in India with regard to inherited property and how capital gains tax is levied on inherited property when it is sold.
It has been published by Rachit Garg.
Table of Contents
Humans are selfish beings, and personal gain is all that truly matters, but we live in a society, and our development depends on society’s development. In order to survive, public welfare is essential, but this requires monetary support. The annual tax paid by the citizen is the most crucial source. A purchase, a property sale, or a product purchase or production has a tax imposed on it that is legally entitled to the government to be used for a larger good. Further, it is through the taxes we pay that the government carries out civil operations.
The tax rate on every entity or asset differs owing to the variety in nature and possession or acquisition of the property or entity. For instance, income tax, direct tax, wealth tax, gift tax, and many more. Another kind of tax is the capital gains tax, which is levied on profits sold by the investor or owner. The capital gains tax is imposed on the sale of numerous kinds of assets like the sale of bonds, precious metals etc.
However, the current article solely focuses on how and what conditions are based on which capital gains tax is levied on inherited property. So, what is capital gains tax on inherited property? Instead, the primary question shall be, what is capital gains tax?
What is capital gains tax
Before understanding the meaning of capital gains tax, for the sake of clarity, it seems imperative to get acquainted with terms like a capital asset, capital, and capital gains. The meanings and illustrations of the same are enumerated below.
A capital asset is a significant component of capital gains tax. Taxes are levied on the capital asset, and this transaction is known as the tax on capital gains or capital gains tax. Capital assets are those assets which are connected or not connected to a company’s operation or the profession of an individual. These capital assets are part of the organisation for a long time and are usually not sold in the regular course of the company’s or organisation’s operation. For instance, land, building, property, vehicles etc.
A, the owner of company B, purchases machinery for the production of the material required for the development of the final product. This machine is used on a regular basis, will be in the company for a long time, and won’t be sold during the regular course of business.
In Joint Commissioner of Income Tax v. Graphite India Ltd (2003), the Income Tax Appellate Tribunal, Kolkata, observed that the definition of “capital asset” has a wide connotation. The definition, as under Section 2(14) of the Income Tax Act, 1961, is inclusive of all the property of an assessee except those expressly excluded under sub-clauses (i) to (iv) to Section 2(14).
Thus, the meaning of capital assets includes
- any property held by the asset owner which can or cannot be connected to the company or profession of the asset owner.
- any securities in accordance with the regulations under the Securities and Exchange Board of India (SEBI) Act, 1992.
but the definition of capital asset excludes
- any stock-in-trade,
- any moveable property, and
- agricultural property not located in India.
Additionally, various case laws have interpreted that the term “capital asset”, under its purview, includes diverse types of properties.
Further, there are two types of capital assets, short-term like prepaid expenses, cash and cash equivalents, trade receivables etc., and long-term, like land, machinery, vehicles, fixtures etc. The bifurcation of capital assets has an impact on the applicability of tax rates under the subject matter of capital gains tax.
Mr B is a business owner. In the month of April 2020, he purchased land and sold it in December 2021. Here, the capital asset is the land, which has been held by Mr B for less than thirty-six months. Thus, it will be categorised as a short-term capital asset. But if Mr B sold the same land in December 2025, then it would be classified as a long-term capital asset as it is more than thirty-six months old.
Next is capital gains; Section 45 of the Income Tax Act, 1961, defines capital gains. The Section provides that the profits or gains earned due to the transfer of capital assets will be chargeable to income tax under the umbrella of capital gains. These capital gains contribute to the increase in capital asset value. Simply put, the profits or gains incurred from the sale of a capital asset are known as “capital gains”.
A, a person buys land worth Rs. 80,00,000. After a specific time period from the date of purchase, A sells the land at Rs. 90,00,000. Here, the land is a capital asset, and A has profited by Rs. 10,00,000 from the sale of such a capital asset. Thus, A has benefitted by Rs. 10,00,000, which is a capital gain.
Moreover, the capital gains are also divided into short-term and long-term capital gains. The following illustration will help in drawing a line between the two.
Mr A, in April 2021, sold his residential property, which was purchased in December 2017. The said property was sold with a capital gain of Rs. 7,00,000. Since the property was held for more than twenty-four months, it is categorised as a long-term capital gain. With everything being similar, if the property was sold in May 2018, then Mr A has held the property for less than twenty-four months. Thus, in this situation, it is a short-term capital gain.
Calculation of capital gains
The calculation of capital gains is dependent on the type of asset and the holding period that is long-term or short-term. The time period for selling a property is less than thirty-six months from the date of acquisition. While the long-term period is selling a property that is in holding for more than thirty-six months, since March 2017, the time period for immovable property has been reduced to twenty-four months, as referred to in the above illustration.
Before understanding the mathematical formula, it is imperative to understand the individual concepts of the elements constituting it.
- Full value consideration means the consideration received by a seller in return for a capital asset.
- The acquisition cost is the asset’s value when the seller acquires it.
- The cost of the improvement is the cost incurred by the seller to make alterations to a capital asset.
- Transfer expenditure be included wholly and exclusively in connection with such transfer.
The computation of capital gains has been prescribed under Section 48 of the Income Tax Act of 1961.
Capital gains = full value consideration received on transfer – (cost of acquisition + cost of improvement + expenditure incurred on transfer of capital asset).
Additionally, the calculator formula for long-term and short-term capital gains is the same. Except under long-term capital gains,
- The indexed cost of acquisition is derived when the cost of acquisition is multiplied by the inflation index of the year of transfer upon the cost inflation index of the year of acquisition.
For instance, Mr A purchased a piece of land in June 2005 for Rs. 84,000 and sold the same in April 2021 for Rs. 10,10,000 (brokerage Rs. 10,000). Upon computation, the taxable capital gain would be rupees 2,27,589.
- The indexed cost of the improvement is derived when the cost of the improvement is multiplied by the inflation index of the year of transfer upon the cost inflation index of the year of improvement.
Therefore, the above formulas need to be applied for calculating capital gains tax. Nowadays, there are numerous online websites and apps which calculate the same for you, one has to only enter the accurate digits under the headings majorly elucidated above.
Capital gains tax
Capital gains tax is not explicitly defined under the Income Tax Act, 1961, but Section 111A, Section 112, Section 112A, Section 115AB, Section 115AC, Section 115AD, Section 115ACA and Section 115E of the Income Tax Act, 1961, enumerate provisions related to capital gains tax under diverse circumstances and conditions.
Well, despite any legislation defining capital gains tax, the meaning of the same is self-explanatory after knowing what capital assets and capital gains are. Conclusively, capital gains tax is nothing but a type of tax imposed by the government on the individual profiting from the sale of his or her capital asset.
Further, as the entity or asset on which tax is imposed is divided under two heads, short-term and long-term, the capital gains tax also has two types. The difference between the two has been enumerated below.
|Basis of comparison||Long-term capital gains tax||Short-term capital gains tax|
|Meaning||Profit or capital gain from the sale of long-term capital assets. But the gain on depreciable assets is never long-term even though the criteria of more than thirty-six months have been satisfied.||Profit or capital gained from short-term capital assets.|
|Duration of holding capital assets||The capital assets, which are held for a period of more than twenty-four months for immovable property and more than three years for moveable property. These are taxed as long-term capital gains.||The capital assets, which are held for a period of less than twenty-four months for immovable property and below three years for moveable property. These are taxed as short-term capital gains.|
|Applicable tax||20% tax is applicable on long-term capital tax gains, excluding the surcharge and cess.||15% tax is applicable on short-term capital tax gains, excluding surcharge and cess.|
|Profits attained||There are chances of higher profits as the holding period of assets is longer than one year.||There is a probability of lower profits as the holding period of assets is less than a year and there is no established position in the market.|
|Sections||Section 112 of the Income Tax Act, 1961 talks about the tax on long-term capital gains.||Section 111A of the Income Tax Act, 1961, talks about tax on short-term capital gains in certain gains. There is no separate section elucidating the definition of short-term capital gains.|
|Illustrations||Mr A sold his residential property after holding it for more than 24 months for Rs. 9,00,000. As the asset is sold after more than 24 months, it is a long-term capital gain, and Rs. 9,00,000 will be taxed.||Mr B sold his residential property within a period of less than 24 months for Rs. 8,20,000. As the asset was sold in less than 24 months, it is a short-term capital gain and Rs. 8,20,000 will be taxed.|
Therefore, capital gains tax is the tax on capital gains. The tax is due on capital gains for the year the gains are realised. For instance, if a property is sold between 1 April 2021 to 31 March 2022, then the taxes on the gains shall be filed in the financial year 2021-22.
Finally, the illustration below explains the relationship between the concepts dealt with here before.
Mr. A is a farmer who purchases land to cultivate crops. The land purchased is a capital asset for the farmer. After a time period of twenty-five months, the farmer sells his capital asset, which is the land, and gains a profit of Rs. 2,00,000. This capital gain of Rs. 2,00,000 is chargeable to income tax under the heading of capital gains tax.
Capital gains and inherited property
The capital gains tax on inherited property can better be understood with a piece of prior knowledge of the status of inheritance tax in India and which legislation regulates it. However, let’s start with the basics.
What is inherited property
The property that is passed down to the legal heirs of a deceased person is known as inherited property. The property that the legal heir receives is said to be their inheritance. These legal heirs could include a son, daughter, brother, grandchildren etc.
In India, the procedure to inherit property is controlled and regulated by personal laws like the Hindu Succession Act,1956, and Indian Succession Act,1925. For the legal heirs to bequeath the property, a will of inherited property is drafted; if not, the Law of Succession or Inheritance of personal laws carries out the procedure. There are two types of property succession in India- testamentary succession and intestate succession.
Once the property is inherited by the legal heir, he or she is regarded as the new owner of the property. Now, the new owner, or the receiver of the inheritance, is entitled to all matters in regard to the property inherited. For instance, the tax, the income incurred, the losses suffered, etc. Such rights and duties of the receiver of an inheritance are enumerated below.
Firstly, “inheritance tax” means the tax levied on property or money acquired by a person through inheritance. The system of income tax on inherited property in India is unique. In 1985, the inheritance tax, as a concept and practice, was abolished in India. It was referred to as an estate or inheritance tax.
Additionally, Section 56(x)(B) of the Income Tax Act, 1961, provides taxation on gifts received but expressly provides that immovable property received under will or inheritance does not have a tax liability. Even though for the purpose of calculating income tax returns, inheritance or such transfers of property are considered gifts, at times, the above provision of the Income Tax Act, 1961, states that under the purview of gift, inheritance is not included. Therefore, under the legislation of the Income Tax Act of 1961, the transfer of such property is not taxable.
Mr. A owns a property and a three-storey building on the same property. Mr. A was survived by his only son, Mr. B. This property and the building owned by Mr. A are passed down to Mr. B. In this case, there is no law that imposes a tax upon this transfer of property from one person to another.
This means that the law doesn’t levy a tax on the receiver of the inherited property, but there are other situations related to the inherited property where the government imposes a tax on the new owner or receiver of the inherited property. Some of those circumstances are.
- An inherited property often has the capacity to be a source of income for the receiver of the inherited property. This receiver is considered the new owner because the property is legally transferred. The source of the income could be interest or rent. When a new owner collects revenue, it becomes new income which is taxed. Therefore, the new owner or the legal heir is liable to pay the tax on the income earned through the inherited property.
Mr A owns a residential three-storey building which is transferred to Mr B, upon A’s death. Mr B decides to rent out five flats at Rs. 40,000 each. Here, the new income generated by the new owner is Rs. 2,00,000. Mr B is liable to pay tax on the income earned through the inherited building.
Sale of inherited property
- Apart from earning income and being legally entitled to claim it, the new owner is empowered to sell the property. The gain or the loss incurred from such a sale is to be solely borne by the new owner, who is obligated to pay the taxes charged.
Upon a conjoint reading of Section 2(42)A, Section 47(iii), Section 49(1), and Section 55(2) of the central tax legislation, that is, the Income Tax Act, 1961. It can be deduced that the “transfer” of such a capital asset is not considered unless the receiver of the inherited property transfers the inherited property for consideration. Consequently, the capital gains are subject to tax. Therefore, the sale of inherited property is taxable.
A inherited a property worth Rs. 20,00,000 from his father in 2022 and is willing to sell it in 2023. The inherited property is sold at Rs. 25,00,000. The capital gains tax would be assessed here, and B would be held liable to pay the tax.
Now, here the property held by B was for a short term, thus applying short-term capital gains tax on inherited property. But long-term capital gains tax and various other factors are required to be considered to assess the capital gains tax of inherited property or calculate the capital gains tax on inherited property. The factors are-
The amount of time for which an individual has ownership over the property is known as the holding period. The holding period shall start when the previous owner gets possession of the property. The date of new ownership acquired by the legal heir is irrelevant.
Mr. Ramesh acquired land from his mother as a share of the inherited property in April 2021. The land was originally acquired by Mr. Ramesh’s mother in 2002 for Rs. 50,000, and when Ramesh sold the land in 2021, he got gains of Rs. 1,00,000.
Here, the holding period is from 2002-2021, which is more than twenty-four months, constituting a long-term capital gains tax. Mr. Ramesh is liable to pay 20% capital gains on the property.
Cost of acquisition
The cost of acquisition is the cost at which the property was acquired. The amount of money invested by the previous owner to acquire the property shall be deemed the cost of acquisition. For instance, in the above illustration, the cost of acquisition was Rs. 50,000.
For property acquired before 1st April 2001, the assessee can use the fair market value as of 1st April 2001 as the cost of acquisition or the cost of the asset as acquired by the previous owner. Here, the fair market value shall not exceed stamp duty as on 1st April 2001.
Cost of improvement
The term cost of the improvement is self-explanatory; it basically means the cost incurred by the assessee for the improvement or completion of the capital asset. The costs borne by the previous owner can also be added.
The cost of improvement would include renovating or modifying the structure of the property, for instance, by constructing a new room or adding new flooring, but regular maintenance, like painting the property periodically, is not included under the head of improvement expenses.
The indexation benefit allows the assessee to inflate or increase the price of the asset. This means that the inflation index can be used to show the impact of inflation on costs. The indexation benefit can be implied from the time of the previous owner, just like the cost of acquisition is deemed the acquiring cost by the previous owner.
Earlier, the initial period of consideration of the indexation benefit was ambiguous. However, in Commissioner of Income Tax v. Manjula J Shah (2013), the Bombay High Court held that the indexation benefit incurred by the previous owner should be considered just as the holding period by the previous owner is taken into consideration.
Therefore, the above-mentioned four points are the factors that contribute to calculating the capital gains tax on inherited property. The amount taxable is determined by these factors, and the capital gains on inherited property are levied accordingly. Moreover, this is how capital gains tax on inherited property is governed and regulated.
Ways to save capital gains tax
The taxes levied on profits generated from property sales are huge. Fortunately, there are ways to save tax on the money earned by selling property or assets; they are
- Reinvest the money earned into buying within two years or constructing a new residential unit within three years. It is under Section 54 of the Income Tax Act of 1961 that further provisions regarding the same are prescribed.
- Direction of funds towards bonds issued by the Central Government. For instance, in the National Highway Authority of India (NHAI), Power Finance Corporation Ltd (PFC), and Indian Railways Finance Corporation Limited (IRFC). The investment shall be made within six months from the sale of the inherited property. Also, to avoid the tax, the maximum eligibility amount for investing is rupees fifty lakhs in a financial year.
- To invest in Capital Gains Account Scheme, 1988, interested candidates can open a “capital gains account” in authorised Indian banks. This amount deposited shall be utilised within two years.
On the face of it, the taxation system provided by legislation may seem complicated, but a basic understanding of essential concepts and the nature of terms like capital assets, capital gains, inherited property, and others simplifies the comprehension of capital gains tax on inherited property. In India, as per the legislation, inherited property is not taxable, but when the legal heir receives the property and decides to actively utilise it, the government levies tax.
The tax rate imposed varies due to factors like the holding duration of the property, which categorises the gains as short-term or long-term. Further, the time of acquisition, etc., helps decide the appropriate tax rate.
Therefore, an inherited property is not free from tax liabilities; the sale of an inherited property comes with tax outlays that impose capital gains tax.
Frequently Asked Questions (FAQs)
What is the difference between capital and capital assets?
Capital means financial support in form of money. While capital assets are a collection of assets like land, vehicles, etc. This doesn’t include money.
What is the inflation index?
Firstly, the cost of the inflation index is calculated in order to match the inflation prices, so an increase in the inflation rate will consequently increase the prices. It is basically a concept which is used to estimate the increase in prices of goods and assets year by year due to inflation. A cost of inflation index is used to calculate long-term capital gains from capital assets transfer or sale.
The cost of the inflation index (CII) varies every financial year; for 2023-24 CII is 348.
Is cryptocurrency considered a part of capital assets?
Until 2022, any virtual digital asset was considered a capital asset. However, the 2022 budget stated that cryptocurrency is considered a special asset, and the tax rate would be 30% without expenses, without indexation, and without carrying forward issues to further years and without the set-off against any income within the year.
What is meant by fair market value?
The fair market value is the price at which the property is exchanged between a willing and informed buyer to a willing and informed seller. Thus, the parties involved are well aware of the facts and act in their own interests while exchanging an asset.
How are capital gains taxable on property inherited by more than one person?
A jointly inherited property, when sold, the capital gains tax shall be paid by every owner. Despite every owner being taxed, the chargeable tax may differ as the owners are taxed based on the proportion of the share in the property.
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