Capital Gains Tax Explained

Last Updated on November 8, 2023 by BFSLTeam BFSLTeam

Capital gains refers to the earnings accumulated from selling any capital asset. These kinds of profits may be made via the sale of either an investment property or a real estate property.

Gains on investments may be either short-term or long-term, depending on how long they are expected to be held. As a result of the fact that earnings are classified as “income”, they are subject to taxes, which is referred to as the capital gains tax.

What is a Capital Gain Tax?

The tax imposed on profits, made from the sale of assets, is called the “capital gain tax”. When an asset changes hands from one owner to another, a tax of this kind is charged. Although all capital gains are subject to taxation, the methods used to calculate taxes on long-term profits and short-term gains often differ. Those subject to taxes on their capital gains might lessen the impact of such taxes by using tax-efficient financial practices. Here is an illustration of how the process works:-

In July 2004, Mr B spent ₹ 50 Lakh on the acquisition of a home. For the 2016–2017 fiscal year, the total value of the consideration amounted to one and a half billion rupees. Since the above mentioned property was kept for over three and a half years, it would be considered a long-term capital asset.

After considering the inflation, an adjustment was made to the cost price, and the indexed purchase cost was also considered.

As a result, the final value of the property’s adjusted cost was determined to be 1.17 billion rupees, which indicates that Mr B realised a net capital gain of 63 lakh rupees. After the application of a long-term capital gains tax rate of 20% to the taxable amount of the net capital gain, the amount of Mr B’s tax obligation that was due was determined to be a total of ₹ 12,97,800.

Types of Capital Gains Taxation

Several types of Capital Gains exist depending on how long one expects to hold onto their investment. These are the two categories of capital gains:

• Short-Term Capital Gain
• Long-Term Capital Gain

Gains from selling an asset during the first 36 months after acquisition are considered short-term capital gains. In contrast, profits from selling an asset after owning it for more than 36 months are considered long-term capital gains.

The period during which capital gains are considered short-term varies, depending on the kind of asset. Listed stock shares, for instance, are only eligible for short-term profits if the holding period is shorter than a year. After then, it’s considered a long-term capital gain.

Units of UTI, whether quoted or not; Units of an equity-oriented mutual fund, whether quoted or not; Zero coupon bonds, whether quoted or not; and any other securities listed on a recognised stock exchange in India are also subject to this regulation. Estimating whether an asset is a short-term or long-term capital asset also considers how long the previous owner held onto it, which is relevant when an asset is acquired by succession, inheritance, gift, or bequest. Nevertheless, the holding term is calculated from the date of issuance of bonus or rights shares, depending on the circumstances.

As the holding period for immovable properties like real estate was increased to 24 months as of March 31, 2017, the period during which capital gains are considered short-term has been shortened to two years.

Regulations on Short-Term Gains and Long-Term Gains Taxation

The Income Tax Act, Section 80C, allows for the following:

• If an investor chooses to sell an asset they have held for less than a year, they will be subject to a tax on the short-term capital gains at a rate of 15%.
• A long-term capital gains tax on mutual funds will be paid 10% on profits made by equity-oriented funds and shares that are more than one lakh rupees.

How to Calculate Capital Gains?

When calculating your taxable profits for the year, you may reduce your overall total by deducting any capital losses from any capital gains.

The calculation will become more difficult if you have experienced both capital gains and losses on short-term and long-term investments. Then, segregate earnings and losses over the short term from those over the long term by placing them in distinct piles.

To calculate the overall short-term benefit, it is necessary to reconcile all of the short-term profits. After then, a total of the short-term losses is determined. The last step is to calculate both short-term and long-term benefits and losses.

When the short-term profits are compared to the short-term losses, the result is either a net gain or a net loss over the short period. A similar thing is done with the profits and losses over the long run.

Capital Gains Tax Strategies

The capital gains tax diminishes investment returns. Some investors may be able to minimise or even eliminate their annual net capital gains taxes.

Among the easiest methods is waiting more than a year before selling assets. That’s a smart move since the tax rate on long-term capital gains is often lower than on short-term ones.

Consider Investing Your Capital Losses

Since capital losses may be used to cancel out capital gains, this strategy can be used to reduce the amount of tax owed on capital gains for the year.

Keep in Mind the Wash-Sale Rule

One should exercise caution when selling the stock at a loss to reinvest the proceeds in the same company. The IRS’s wash-sale rule prohibits such a chain of transactions if it is completed in less than 30 days.

Capital Gains Tax Explained

One of the numerous advantages of contributing to a retirement plan like a 401(k) or an Individual Retirement Account is that your investment earnings accumulate tax-free yearly. In other words, all transactions conducted inside a retirement plan are exempt from annual taxation. Withdrawal from the plan is often when taxation becomes due for the member. Regardless of the investment, withdrawals are subject to ordinary income taxation. A Roth IRA or Roth 401(k), in which income taxes are deducted from contributions before they are deposited, allows for tax-free withdrawals under certain circumstances.

Profit from Retirement

Once you’ve officially stopped working, it may be wise to hold off on selling off lucrative assets. In retirement, your income will likely be smaller, which might lessen your capital gains tax liability. You won’t owe any capital gains tax at all. Think carefully about how absorbing the tax burden while working instead of in retirement may affect you. Gains realised before the end of the tax year may result in a higher tax bill since they will have moved you out of a lower or no-tax bracket.

Be Aware of Holding Times

Always remember that to be considered a long-term capital gain, an asset must be sold more than a year after it was first acquired. Be cautious to verify the acquisition’s transaction date before selling securities you acquired around the same time last year. By waiting only a few days, you can escape taxation of the gain as a short-term capital gain. Naturally, these timing manipulations become more significant with larger deals. Similarly, if your income puts you in a higher tax bracket, you won’t benefit more than someone in a lower bracket.

Make a Decision

When purchasing and selling shares of the same firm or mutual fund at various dates, most investors utilise the first-in, first-out (FIFO) technique to determine the cost basis. The other four options are last-in, first-out (LIFO), dollar-based LIFO, the average cost (exclusive to mutual fund shares), and individual share identification. The purchase price of the shares or units and the anticipated gain will both play a role in determining which option is preferable. You should talk to a tax professional in more complicated situations.

When Do You Owe Capital Gains Taxes?

The capital gains tax is due in the year you pocket the profit. If you sell stock at any point in 2022 for a profit, you must include that amount as a capital gain on your tax return for that year.

After selling an investment held for more than a year, capital gains taxes become due. Schedule D is used to detail the tax burden.

According to your annual taxable income, the capital gains tax rate might be 0%, 15%, or 20%. A higher tax rate applies to those with higher incomes. Each income cap is recalculated to account for rising prices. Profits from assets held for less than a year are categorised as short-term gains and are taxed at the regular income rate. Generally speaking, that’s a greater rate than most individuals experience.

How Can You Avoid Capital Gains Taxes?

Taxes on capital gains are something to consider if you plan on investing money and making a profit. You may legally reduce your capital gains tax liability in a variety of ways. Here are few tips to avoid capital gains tax:

• Keep holding onto it for more than a year. Otherwise, the gain will be considered normal income, resulting in higher taxes.
• Some investors capitalise on such knowledge. At the end of the year, for instance, you may unload a losing position to balance off any profits you’ve made.
• Keep track of the money you spend on your investment, whether initial costs or ongoing servicing. This is because they will increase the investment’s cost basis, lowering its taxable gain.