Introduction
One of the major sources of income for the government is the tax collected from its citizens. Taxes are an interim part of any individual’s earnings. From your salary to business to investments, everything is taxable at one rate or the other. There are various classifications for the taxability of your source of income. One such classification is the gains from your capital assets.
This article elaborates on what capital gains are in detail.
What are Capital Gains?
The increase in the value of a capital asset at the time of selling is known as capital gains. In other words, a capital gain is a profit you earn by selling an asset for more than you originally paid for it. This applies when an asset is sold at the sale price less the original purchase price. The Income Tax Department taxes an individual on their gains on capital in certain circumstances.
Almost every type of asset you own is a capital asset; whether it's a type of investment instruments like stocks, bonds, or real estate, or purchased for personal use like furniture, and boats, among others.
You must claim capital gains tax on short-term (one year or less) or long-term (more than one year) income. Unrealized gains and losses reflect an increase or decrease in the investment value, but are not considered taxable capital gains. A capital loss occurs when the value of an investment decreases relative to the asset's purchase price.
Capital gains' meaning is evident and self-explanatory in its name. A capital gain is an increase in the asset’s value or investment resulting from the asset or investment’s price appreciation. In other words, a profit occurs when an asset or investment's current or sale price exceeds its purchase price. Capital gains are attributed to fixed assets of any kind, including but not limited to stocks, bonds, goodwill, and real estate.
Understanding Capital Gains
According to the capital gain definition, it occurs when you sell an asset at a profit. While capital assets can be anything from investments to personal use purchases, capital gains are generally associated with investments such as stocks and bonds due to their price volatility.
There are two types of Capital gains:
1. Short-term capital gain: Short-term capital gain (STCG) is realised on capital assets held for one year or less
2. Long-term capital gain: Long-term capital gain (LTCG) is realised on capital assets held for more than a year
You can claim both these types of gains on your annual tax return. Understanding and incorporating this difference into your investment strategy is especially important for day traders and others who benefit from the ease of trading the markets online. A capital gain occurs when an asset is sold and a claimable event occurs. Unrealised gains, also known as paper gains and losses, reflect increases or decreases in investment value but are not considered capital gains and should be treated as billable events.
For example, you purchased 100 shares of ABC stock on January 30, 2020, at INR 350 per share. You then sell all the shares on Jan. 30, 2020, for INR 800 each. Assuming no fees were associated with the sale, you realised a capital gain of INR 45,000 (INR 800 x 100 - INR 350 x 100 = INR 45,000).
Here, your INR 45,000 becomes your taxable capital gain.
Types of Capital Assets
1. Short-term Capital Assets
An asset is categorised as a short-term capital asset when it is held for 36 months or less. The standard is 24 months of immovable properties such as land, buildings, and houses from 2017-18. For example, if you sell a home that you have owned for 24 months, and the property is sold after March 31, 2017, the resulting income will be treated as a long-term capital gain.
The 24-month reduction period mentioned above does not apply to personal property such as jewellery, liability-oriented investment funds, etc. This rule applies if the transfer date is after July 10, 2014 (regardless of the purchase date). These assets are:
● Shares or preferred shares of companies listed on any recognized stock exchange in India
● Securities listed on any recognized stock exchange in India (corporate bonds, bonds, government securities, etc.)
● UTI units, quoted or not
● Shares of equity-oriented mutual funds, regardless of whether they are listed or not
● Zero-coupon bonds (ZCBs), regardless of whether they are listed or unlisted
2. Long-term Capital Assets
An asset is categorized as a short-term capital asset when it is held for more than 36 months. Fixed assets such as land, buildings, and residential properties are considered long-term assets if they have been held by the owner for 24 months or more (2017-2018).
On the other hand, the assets listed below are considered long-term investments if held for 12 months or more.
● Shares or preferred shares of companies listed on any recognized stock exchange in India
● Securities listed on any recognized stock exchange in India (corporate bonds, bonds, government securities, etc.)
● UTI units, quoted or not
● Shares of equity-oriented mutual funds, whether listed or not
● Zero-coupon bonds (ZCBs), regardless of whether they are listed or unlisted
Not all investment instruments fall under the capital gains rates. Below is a list of eligible and ineligible assets.
Eligible assets: Stocks, Bonds, Jewelry, Cryptocurrency, Homes and household furnishings, Vehicles, Collectibles, Timber, and fine arts.
Ineligible assets: Business inventory, Depreciable business property, the Real estate used by your business or a rental property, Copyrights, Patents, Inventions, Literacy, or Artistic compositions.
Classification of inherited Capital Assets
For an asset acquired by gift, will, succession or inheritance, the period the original buyer held the asset is also important to determine if it is a short-term or long-term gain. For bonus shares or rights, the holding period is counted from the date of allocation of the bonus shares or rights.
Tax Rates – Long-Term Capital Gains and Short-Term Capital Gains
There are different tax rates based on the different conditions of the asset’s sale. Below is the applicable tax for those-
1. Long-term capital gains on the sale of equity shares or equity-oriented units are taxed at 10% over and above INR 1 lakh.
2. Long-term capital gains on selling anything except equity shares or equity-oriented units are taxed at 20%.
3. When the Securities Transaction Tax (STT) is not applicable, the short-term capital gain is added to your income tax return and the taxpayer is taxed according to income tax slab rates.
4. Short-term capital gain is taxed at 15$ when the STT is applicable.
How Do Mutual Funds Account for Capital Gains?
The treatment of capital gains on equity funds and debt funds is different. Debt mutual funds are categorised as long-term assets only when they are held for 36 months or more. It means you will need to hold the fund for at least three years to take advantage of LTCG for your debt mutual funds. If you redeem your funds within 36 months, it is taxable as per your income tax slab. A long-term capital gain on debt mutual fund is taxable at 20% with indexation.
With effect from 11 July 2014, short-term gains from equity mutual funds are taxed at 15% while long-term gains are taxed at 10% over and above INR 1 lakh without indexation.
Tax-conscious mutual fund investors should determine the mutual fund's cumulative unrealized capital gains as a percentage of net worth before investing in a fund that contains a material unrealized capital gains component. This situation is called the capital gains risk of the fund. When distributed by the Fund, capital gains are taxable to the Fund's investors.