When it comes to investing in mutual funds and other assets, capital gains play a significant role in determining the returns on investments. Capital gains can be categorised as long term or short-term based on the holding period of the asset. In this article, we will delve into the world of long term capital gains tax (LTCG), exploring what it is, how it is calculated, the tax rate, and the exemptions available to investors. Understanding LTCG tax can help investors make informed investment decisions and manage their tax liabilities.
What is long term capital gains tax?
Long term capital gains tax is a tax levied on the profits earned from the sale or transfer of certain long term assets, such as stocks, real estate, mutual funds, or other investments. The tax is applicable only when these assets are held for a specific period, typically more than one year, before they are sold.
When you sell your equity shares after holding them for over a year, you can earn long-term capital gains on mutual funds. If your long-term gains exceed Rs. 1 lakh, you will need to pay taxes on them. The tax rate for LTCG on mutual funds is 10%, and there is no benefit of indexation.
Here are some key points about long term capital gains tax on Mutual Funds:
- Holding Period: To qualify for long term capital gains treatment, an investor must hold the asset for a minimum period of one year or more in case of equity-oriented funds and three years or more in case of other than equity oriented funds. If the asset is sold before this holding period, the gains are considered short-term and are subject to a different tax rate.
- Tax Rates: Equity oriented schemes are subject to Long term capital gains tax at the rate of 10%* and other than equity-oriented schemes are subject to LTCG at the rates are 20%*. * The rates mentioned above are exclusive of cess and surcharge if applicable.
- Tax Benefits: Governments often provide lower tax rates on long term gains to encourage long term investment.
- Reporting: Taxpayers are required to report their capital gains on their income tax returns, specifying whether the gains are short-term or long term.
Understanding long term capital gain tax on mutual funds
Long term capital gains in terms of mutual funds typically refer to the profits made on the redemption or sale of mutual fund units held for a duration of more than one year. These gains are subject to taxation, with different rates applied to equity and non-equity mutual funds:
Equity funds
Equity funds are mutual funds designed for investing in equity shares of various companies. They come in two types: tax-saving equity funds and non-tax saving equity funds.
- Tax-saving equity funds (ELSS)
ELSS, a type of tax-saving equity fund, imposes a lock-in period of 3 years. During this period, investors cannot sell or transfer their funds, leading to long term capital gain tax obligations. - Non-tax saving equity funds
Unlike tax-saving equity funds, non-tax saving equity funds do not have a lock-in period. Depending on the holding period, they can attract both long term and short-term capital gain taxes. All equity funds are subject to a 10% tax on gains above Rs. 1 lakh without indexation benefits after 12 months. However, investors can exempt gains up to Rs. 1 lakh.
For instance, if Mr. Anil invested Rs. 3 lakh in an equity fund on 1/2/17 and sold it on 31/3/2019 for Rs. 4.5 lakh, his capital gain would be Rs. 1.5 lakh. Consequently, a 10% tax would be levied on the Rs. 50,000 exceeding the Rs. 1 lakh margin.
Equity-oriented hybrid funds
These mutual funds invest in both equity and debt funds, with more than 65% of the investment towards equity shares or equity-oriented shares. Hence, they attract a similar long term capital gain tax as equity funds.
Debt funds
Debt mutual funds are used to invest in debt instruments from the market. The long term capital gain tax rate on mutual funds is 20% after indexation, which adjusts the acquisition cost for inflation using the Cost Inflation Index (CII).
Example: Mr. Bose invested Rs. 2 lakh in debt funds on 30/4/15 and redeemed it on 1/2/19 for Rs. 3.5 lakh. Considering the Cost Inflation Index of AY 2015-16 (254) and AY 2018-19 (280), the indexed cost of acquisition would be Rs. 2,20,472, resulting in a long term capital gain of Rs. 1,29,528.
Debt-oriented balanced funds
These funds reinvest more than 60% of the funds towards debt instruments and are subject to a tax rate of 20% after indexation.
It is essential to stay updated with the prevailing tax regulations, as tax rates and rules may change over time.
Long term capital gains tax rates
The Long-Term Capital Gains Tax (LTCG) rates vary across different asset classes:
- Equity Asset Classes: For gains from equity mutual funds, the LTCG tax rate is 10%, without indexation benefits. Profits up to Rs. 1,00,000, however, enjoy an exemption from taxation. Similarly, the sale of listed equity shares attracts a 10% tax on gains under LTCG provisions, with an exemption of up to Rs. 1,00,000. In contrast, gains from the sale of unlisted shares are taxed at a 20% LTCG rate after considering indexation benefits.
- Debt Assets: For debt instruments such as bonds and mutual funds, the LTCG tax rate is 20%, factoring in indexation benefits.
- Real Estate and Other Assets: LTCG from the sale of real estate assets, gold, and other metals is taxed at a rate of 20% with indexation. This uniform rate is applicable to these non-equity asset classes.
Here is an example for better understanding:
Suppose Mrs. Gupta invests in equity shares worth Rs. 35,000 and sells them outside a recognised stock exchange after 25 years for Rs. 7,50,000. Her indexed cost of acquisition (Rs. 35,000 * 320/100) amounts to Rs. 1,12,000.
After deducting this from the selling price, her taxable gain stands at Rs. 6,38,000. Opting for indexation, she incurs a 20% tax on this total amount, resulting in Rs. 1,27,600.
Alternatively, if she chooses not to avail indexation, the taxable gain is calculated by deducting the selling price and the cost of acquisition (Rs. 7,50,000 – Rs. 35,000 = Rs. 7,15,000). Tax is calculated at 10% of this taxable amount, totaling Rs. 71,500.
How to calculate LTCG tax?
- The calculation of LTCG tax depends on the type of asset and the applicable tax rate.
- For equity-oriented assets like unit of equity-oriented mutual funds and shares of listed companies, the long term capital gains tax rate is 10% on gains exceeding Rs. 1,00,000. Gains up to Rs. 1,00,000 are exempt from tax.
- For non-equity assets like debt mutual funds, real estate properties, and gold, the LTCG tax is 20% after indexation. Indexation helps adjust the purchase price of the asset for inflation, reducing the taxable gains.
Changes in long term capital gains tax on mutual funds
Before 2018, if you invested in equity funds or equity-oriented hybrid funds for a long time, you did not have to pay any tax on the gains you made when you sold them. But in 2018, the finance bill made some big changes. It introduced a tax called LTCG (Long-Term Capital Gains) tax, which is 10% on any gains above Rs. 1 lakh from such investments. However, there was a special rule called grandfathering that protected any gains made before February 1, 2018.
The Ministry of Finance is considering about getting rid of the LTCG tax on mutual funds that you hold for more than three years. They hope this will encourage people to invest for the long term and make the market more stable.
What are the exemptions on long term capital gains tax?
- There are certain exemptions available to investors on long term capital gains under various sections of the Income Tax Act, 1961.
- For example, Section 54 provides an exemption on LTCG tax if the gains from the sale of a residential house property are reinvested in another residential house property within the specified period.
- Under Section 54EC, capital gains up to a maximum of Rs. 50 lakhs, made on the sale of a long term asset, can be exempted if the proceeds are invested in certain specified bonds within 6 months.
- Capital gains arising from the sale of equity shares or units of equity-oriented mutual funds on or after April 1, 2018, up to Rs. 1 lakh in a fiscal year is exempt from tax. Gains exceeding Rs. 1 lakh are taxed at a rate of 10%.
It is important to note that these exemptions have certain conditions and criteria that must be met to claim them.
How to save tax on long term capital gains?
- To save tax on long term capital gains, investors can utilise various tax-saving investment instruments, like Equity Linked Savings Schemes (ELSS) or the National Pension System (NPS).
- By investing in these tax-saving options, investors can claim deductions under Section 80C of the Income Tax Act and reduce their taxable income.
Conclusion
Long term capital gains tax (LTCG) is an essential aspect of taxation for investors. Understanding the holding period of assets, the applicable tax rates, and the exemptions available can help investors optimise their tax liabilities and make informed investment decisions. By exploring various tax-saving options and staying updated with the latest tax regulations, investors can make the most of their long term capital gains and work towards long term wealth creation and financial goals.
As with any tax-related matters, seeking professional advice is advisable to ensure accurate tax planning and compliance with tax laws. Overall, being aware of the tax implications of investment decisions is a key element in sound financial planning.
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