Capital Gain Tax
You and I and everyone else who earns have one thing in common – ‘we all hate the Income Tax Department’. This hatred, to be honest, is a direct result of those corrupt officers and politicians who embezzle the tax collections and get rich at our cost. We wouldn’t really mind if every single penny collected from us in form of taxes was accounted for and put to better use. Truth is, that’s all we can do – just shout and get frustrated and at the end of the day, pay the taxes, even though unwillingly, because we live in a world of political anarchy. Sadly, there is no way out!
Let’s not get into what we can do and what we can’t or what we like or what we hate and get down to business because we are here to learn about capital gain tax. This is a completely different monster whose threat looms not on our income but on any additional money that we make through sale of a capital asset.
When we say capital asset we mean anything like real estate, stocks and shares, etc. These are those assets that we do not earn monthly or daily. We just buy them using our primary income (for most of us it is a job and for some, it is a business). Capital assets have one interesting feature: ‘they will either grow in value or they will diminish in value over time’. Here value refers to the monetary value.
So, there are two possible scenarios:
- We buy a capital asset and then we sell it. The selling price will be greater than the buying price if the capital asset appreciates in value. In such a case,
Selling Price – Buying Price = Profit aka Capital Gain.
- We buy a capital asset and then we sell it. The selling price will be lesser than the buying price if the capital asset depreciates in value. In such a case,
Selling Price – Buying Price = Loss aka Capital Loss.
If capital loss occurs, we lose and tax guys will not bother us. If however, capital gain occurs, the tax guys will show up demanding that they need a cut of the profits we made the sales because that’s the law. This cut in profit or capital gain that they demand is called capital gain tax. It is NOT the same as income tax.
Time to dig deeper…
Now that we have a decent idea of what a capital gain tax is, we can move ahead and learn a few more things. We will safely ignore discussions on capital loss because tax guys are not concerned about our losses. They are only interested in our profits and so, we will limit our discussion to capital gain.
We said that we can own a capital asset that we can sell. They question is, how long can we hold and what are the implications of the duration of holding. There are again two scenarios:
- We hold the capital assets for 36 months or less than that, any profits we make after sales is considered short term capital gain
- We hold the capital assets for 36+ months (i.e. more than 3 years), any profits we make after sales is considered long term capital gain.
When we consider shares that are listed, the holding period used for defining long term capital gain and short term capital gain is different from other capital assets.
For short term capital gain, a listed share cannot be held for 12 months or more. It has to be less than that. For long term capital gain, the holding period for listed shares need to be 12+ months. This same rule applies also for mutual funds.
The big question: How are capital gain taxes calculated?
Both variants of capital gain tax, i.e. short term and long term first call for calculation of net capital gain. Once that is calculated, taxes are applied using different rules.
Here is how short term capital gain is calculated…
NSTCG = FCV – [IE + AC + IC + Exemptions]
NSTCG stands for Net Short Term Capital Gain
FCV stands for Full Consideration Value
IE stands for Incurred Expenditure
AC stands for Acquisition Cost
IC stands for Improvement Cost
Exemptions means any applicable tax exemptions.
Once the Net Short Term Capital Gain is calculated, the usual income tax rules are applied for tax calculations.
Here is how long term capital gain is calculated…
NLTCG = FCV – [IE + IAC + IIC + Exemptions]
NLTCG stands for Net Long Term Capital Gain
IAC stands for Indexed Acquisition Cost
IIC stands for Indexed Improvement Cost
Once Net Long Term Capital Gain has been calculated, a tax rate of 20% is applied. Apart from that, there are some advanced taxes that are also applied.
Explanations for the components of capital gain calculation
Full Consideration Value: When someone sells capital asset, he or she gets something in return. It is usually cash but it can also be something in kind. Even if it is in kind, that object has some value. In case of cash, the full consideration value is the total cash amount. However, in case the payment comes in form of kind, the full consideration value is calculated on fair market value of the item. Fair market value in this particular context will mean the actual cash that can be gained by selling the item in open market on the date when the valuation is done.
Incurred Expenditure: Before and during the selling process of the capital asset, the seller needs to spend some money. The total cash value of these expenses is known as incurred expenditure. There can be a few types of incurred expenditure:
- Brokerage fee.
- Advertisement costs.
- Legal costs.
- Registration fee.
- Stamp duty.
Acquisition Cost: Acquisition cost is the total cost incurred by the seller when he or she actually acquired the capital asset. During an asset acquisition, there is a particular thing called title completion cost. This cost is also included during the calculation of acquisition cost. There may be instances when the seller actually did not buy the asset but rather received it from someone else as a succession or a gift or inheritance or he or she may have received the same as a distributed asset after a company was liquidated. In such scenarios, the acquisition cost of the seller is the acquisition cost of the person who previously owned the asset. If for some reason, the acquisition cost of the previous owner cannot be calculated, the acquisition cost is calculated as the fair market value.
Improvement Cost: After a person has acquired an asset, he or she may consider making alterations or perhaps additions to the asset. Such alterations or additions are considered as improvements to the asset. Expenses for such improvements are called improvement costs.
Indexed Acquisition Cost: In case an asset has been under possession for long term, inflationary factors pitch in. Under such conditions, tax rules allow for some market corrections to minimize the different between acquisition cost and selling price. The inflationary correction thus made to acquisition cost is known as indexed acquisition cost.
Indexed Improvement Cost: The same applies for improvement costs when an asset is sold after long term possession. Inflationary corrections are must. When such corrections are made, the improvement cost is termed as indexed improvement cost.
Follow this link if you are willing to learn of the Cost indexed values,this link which gives a detailed overview of the entire method used. We will not include the explanation here to avoid making the article unnecessarily long.
Exemptions: This is pretty self-explanatory. Just like exemptions in income tax, there are exemptions in capital gains taxes. Exemptions for short term capital gain can be availed under sections:
Exemptions for long term capital gain can be availed under sections:
Just to make it clear, all exemptions cannot be enjoyed at once. Different exemptions apply under different circumstances. You will need to talk to your tax guy to know which exemption applies in your case.
Well, that’s pretty much the summary of Capital Gain Tax. There are of course many other details but covering them in one single article is literally not possible.
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