When starting their investment journeys, investors are often confused between income tax and capital gains tax. Income tax is the tax collected on earnings from different income sources like salary, wages, interest, rental income, etc. Capital gains tax is the tax collected on the profits earned due to the sale of a capital asset like shares of a company, mutual fund units, or property. In a nutshell, capital gains tax is a smaller subset present within the broader ambit of income tax.
This article is a guide on the income tax vs. capital gains tax debate. It highlights the applicability of each tax, the key differences between the two, and how investors can optimise their liabilities.
Are capital gain tax and income tax the same?
While income tax and capital gains are not the same, the latter is a subset of the former. Income tax is a direct tax applicable on income from multiple sources like wages, salaries, interest, rent, royalties, etc. Capital gains tax, on the other hand, is the tax applicable on the profits you earn from sales of capital assets like shares, mutual funds, and property.
What is income tax?
Income tax refers to the direct tax imposed by the government on the income or profits of taxpayers, both individuals and businesses. According to tax laws, every taxpayer needs to file their income tax returns to determine their tax liabilities for the relevant year. Income tax is collected on various types of income earnings, including salaries, wages, rent income, profits, interest, royalties, etc.
Income tax is collected according to the government-regulated tax brackets in a country. In other words, the income tax payable by the taxpayer varies depending on the applicable tax bracket, which is based on the amount of income earned by the individual in the given year. Most countries have a progressive income tax regime, whereby those earning higher incomes are taxed at a higher rate.
Income tax is a primary source of revenue for the government. The government uses the collected tax proceeds to fund various projects, finance fiscal deficits, and meet other developmental expenditures.
What is capital gains tax?
Capital gains tax is the tax collected on capital gains from the sales of capital assets like stocks, mutual funds, and real estate. Capital gains refer to an increase in the value of a capital asset. This gain is only realised if the asset is sold for a higher valuation. The profit earned from such sales is subject to taxation.
Moreover, capital gains tax is applicable based on the holding period of the asset. Generally, assets held for more than 12 months are subject to long-term capital gains taxes, while those with a shorter holding period than 12 months are subject to a short-term capital gains tax. However, governments can prescribe and revise holding periods for different types of capital assets from time to time. For instance, in India, equity MFs are taxed at 20% in the short term and 12.5% in the long term (as of 23rd July 2024). However, debt funds are taxed as per the investor’s tax slab if you sell them within 3 years (funds bought on or after 1st April 2023).
Difference between income tax and capital gains tax
Both income tax and capital gains tax play a crucial part in the economy as both enhance the government’s revenue. However, as taxpayers, you should understand the income tax vs. capital tax debate in detail to know when which tax is applicable. The following table sums up the differences between income tax and capital gains tax in detail:
| Parameter | Income Tax | Capital Gains Tax |
| Definition | Income tax is the direct tax levied by the government on the income earned or profits generated in a given financial year. | Capital gains tax is a tax applicable on the profits earned from the sale of a capital asset. |
| Taxation source | Income tax applies to various earnings sources including salaries, wages, interest, rent, royalties, etc. | Capital gains tax is applicable on the sale of assets like stocks, mutual funds, real estate, etc. |
| Tax determination | Income tax is variable based on the applicable tax bracket of the taxpayer. The government reserves the right to revise tax brackets as and when needed. | The amount of capital gains tax collected depends on the holding period of the asset. |
| Categories included | Income tax includes five main categories: income from salaries, income from business/profession, income from sale of capital assets, income from rent, and income from other sources like interest on FDs. | Capital gains tax includes two main categories, namely, short-term capital gains tax and long-term capital gains tax. |
| Scope of coverage | Income tax has a wider scope since it also includes capital gains tax as a subset. | Capital gains tax has a narrower scope of applicability than income tax. |
Income Tax vs. Capital Gains Tax Example
Let's say Ravi, an Indian taxpayer, earned Rs. 3,50,000 in 2023. For his income tax, he would have paid 5% on the first Rs. 2,50,000 of income and 10% on the income beyond that, up to Rs. 5,00,000 (Rs. 3,50,000 - Rs. 2,50,000 = Rs. 1,00,000). His total tax liability would be Rs. 7,500 (Rs. 2,500 + Rs. 5,000).
Now, if Ravi sold an asset within a year, resulting in a short-term capital gain of Rs. 10,000, this amount would be added to his income and taxed at his applicable rate of 10%. This means an additional tax of Rs. 1,000 (10% of Rs. 10,000).
However, if Ravi held the asset for over a year before selling, his gain would qualify for long-term capital gains tax, which in India is typically 10% for listed securities, above an exemption limit of Rs. 1,00,000. This lower rate would reduce his tax liability, making it beneficial to hold onto investments longer.
When do capital gains apply?
From the income tax vs capital gains tax comparison discussed above, it is clear that capital gains taxes apply only in certain instances. Capital gains tax is a subset of the broad income tax umbrella. This type of tax applies when capital assets like shares, mutual funds, and property are sold or transferred. Capital gains refer to the profits you make upon selling such capital assets.
It is important to note that simply the possession of capital assets does not attract a capital gains tax. Assets that you hold till death or donate to charity are free from such taxation. Only the income derived from the sale or transfer of a capital asset attracts capital gains taxes. Additionally, you should also note that capital gains taxes are applicable in the year the sale or transfer happens.
When does ordinary income tax apply?
As mentioned in the differences between income tax and capital gains tax, ordinary income tax applies to the taxpayers' annual income. The taxpayer in question may be an individual or a business entity. Ordinary income includes not just salary but also earnings from various sources, including interest on bank deposits, income from professional services or business, rental income, and income from the sale of capital assets.
Income tax is payable only if the total annual income of the taxpayer exceeds a certain threshold. The government specifies the income tax structure, setting the minimum threshold for income tax exemption. If the taxpayer's total income is below this minimum threshold, they do not have to pay income tax. For instance, according to the new tax regime, annual income of up to Rs. 3 lakh is exempted from income tax. Beyond that, income tax calculations are based on the new tax slabs applicable for the relevant year.
Capital gains and income tax in practice
Understanding the income tax vs capital gains tax debate becomes easier when we consider practice examples of how each impacts various assets. Here’s how income tax and capital gains tax differ when it comes to different asset classes:
1. Mutual funds
Investing in mutual funds can generate both income and capital gains. When mutual fund units are sold for a profit, MFs generate capital gains, which are subject to taxation. On the other hand, if you invest in mutual funds that pay dividends, the dividend income is taxed under ordinary income tax.
2. Real estate
When you sell a property or piece of land for more than what you paid for, you generate a profit. Since this is a profit from the sale of a capital asset, it attracts a capital gains tax. However, if you rent out your house, the rental income from the same will be considered a part of your total annual income and taxed according to the applicable income tax slab.
3. Stock investments
Capital gains taxes are levied on the sale of stock investments. A short-term capital gains tax is applicable if you sell a company’s shares within a year of ownership, while a long-term capital gains tax is applicable if you sell the shares after a year. In most countries, the LTCG tax rate is lower than the STCG tax. In India, STCG on stocks stands at 20%, while LTCG stands at 12.5% (if the profits exceed Rs. 1.25 lakh).
4. Small business
If you are a small business owner, any profits you make from the business during the course of the fiscal year will be subject to income tax. However, if you sell the business, the profit from the sale will be considered a capital gain and taxed accordingly.
Which is better for investors – Capital gain tax or income tax?
Investors tend to favour capital gains tax over income tax because the former typically has a lower rate than ordinary income tax rates. This is especially true for long-term investments that are held over a year. In other words, holding an asset longer allows investors to lower their tax liabilities and earn compounding returns. Moreover, capital losses of prior years can be used to offset capital gains in the present year, allowing investors to further minimise their outstanding liabilities. On the other hand, income tax applies to the investor's annual income.
Key Takeaways
- Income tax applies to earnings from sources like salary, rent, and interest, while capital gains tax is levied only on profits from selling assets like stocks, mutual funds, or property.
- Income tax covers various income types and applies annually, while capital gains tax applies only when capital assets are sold, with rates based on the holding period.
- Long-term capital gains generally have a lower tax rate compared to short-term gains, which incentivises investors to hold assets longer.
- Investors can often reduce liabilities with capital gains tax due to its typically lower rates and by using past capital losses to offset current gains.
- Understanding the differences enables better tax planning, helping taxpayers optimise liabilities and leverage long-term gains through platforms like Bajaj Finserv Mutual Fund.
Conclusion
To sum up, both income tax and capital gains tax are taxes implemented by the government to collect revenue that funds various developmental projects. Despite this similarity, there are several differences between income tax and capital gains tax. If you are a salaried employee or a business owner with an annual income above the minimum income threshold, you are liable to pay an income tax on the same as per the applicable tax slab. Alternatively, if you sell capital assets like stocks or mutual funds for a profit, the profit generated qualifies for a capital gains tax. The tax rate on such profits is either short or long-term based on how long you have maintained ownership of the asset.
Learning about the ins and outs of capital gains tax is crucial for investors seeking to earn more through mutual fund schemes and investments. Now that you know the differences between income tax and capital gains tax, it's time to start investing through the Bajaj Finserv Mutual Fund Platform. Here, you can browse different types of mutual fund schemes, compare 1000+ mutual funds, estimate returns with the in-house mutual fund calculator tool, and more—all with a few easy clicks!
