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Rental Income And Capital Gains On Sale Of Property: The Tax Implications

This post is contributed by Paisabazaar.

Property investments are typically considered one of the safest and most lucrative investment options. 

However, property investments made with the objective of (a) earning rental income or (b) higher returns due to value appreciation, are also the most complex transactions.

There are tax-related and other implications associated with your property transactions. Therefore, one needs a fine understanding of these nuances.

Basic details on capital gains

Property is considered as a capital asset. Thus, any profit (or loss), that is generated from the sale of property, is subject to tax as per Income-tax rules. This comes under the ambit of capital gains. 

In case the property is inherited, mere transfer of ownership won’t attract any tax liability. But, if this inherited property is sold further after transfer, then the capital gains tax will be charged.

Capital gains are segmented in two categories i.e. Short term or Long term. 

If the property is sold within 3 years (36 months) of purchase, then the profits will come under Short Term Capitals Gains (STCG). Here, the profit made will be added to the total taxable income, and then taxed as per the individual’s respective income slab. 

If the property is sold after 3 years (36 months), the profits will be treated as Long Term Capital Gains (LTCG) and taxed at a flat rate of 20% after indexation benefit (plus surcharge and cess as applicable). 

Broad calculations involved in deriving capital gains

Short term or Long term Capital gains can be calculated as mentioned below:

Short Term Capital gains
Long Term Capital gains
1.    Start with
Sale price of property

2.    Less
Expenditure incurred wholly and exclusively in connection with transfer of capital asset (e.g. brokerage, commission, etc.)

3.    Less
Cost of acquisition

Indexed cost of acquisition ^^
4.    Less
Cost of improvement

Indexed cost of improvement ^^
5.    Less
Exemptions provided under sections 54, 54EC, 54F, 54B

6.    Net gains

Note ^^: Indexation is a process by which the cost of acquisition is adjusted against inflationary rise in the value of asset; using ‘Cost inflation index’ as notified by the Government and published by Reserve Bank of India (RBI). The benefit of indexation is available only to long-term capital assets.

How to save tax on sale of property? 

Under Section 54, exemption from the LTCG Tax can be claimed, by reinvesting the capital gains or sale proceeds in specified investment avenues as per IT rules. 

One can save LTCG tax by investing in another residential property (not commercial), but within a stipulated time period. For flats, it’s two years and for constructing a new house it is three years. Claim can also be availed if a new property is purchased one year prior to the transfer of the property sold.

There are cases where investor fails to reinvest in another property before filing annual IT returns. In such cases, one option is to deposit the money in a separate account with a nationalized bank as per the Capital Gains Account Scheme (CGAS). Such accounts can be opened only with specified banks or institutions as notified by Government. Money from CGAS can be withdrawn specifically for purchasing a new property only and this account can be used for only up to three years.

Under section 54 EC, another option is to invest the money in certain bonds [such as bonds issued by National Highway Authority of India (NHAI) or Rural Electrification Corporation (REC)] that are specified by the government. But here again certain rules are to be followed.
  • First, there is a ceiling on the amount to avail tax benefit of up to Rs. 50 lakh only, and rest amount is taxable. 
  • Second, investment must be made within 6 months of selling the property. These bonds typically have a lock-in period of three years.

Implications on Rental income

As per IT rules, rental income from property is taxable. 

Thankfully, the tax in not applicable on the total rental income; and various deductions are available. 

These include (i) standard deduction at 30% of the taxable value (towards repairs & maintenance), (ii) deduction of property or municipal taxes paid, and (iii) amount of interest paid on home loan. Based on these deductions, the net taxable value of rental income is derived.

In case you have two or more houses, from taxation perspective, one house can be considered as self-occupied. Tax needs to be paid on rental income from your other properties

It is advisable not to keep your second house unoccupied. Even if your second house is empty, as per IT rules, it is deemed as rented and will still attract tax, based on its deemed rental value. 

Renting your second home has another benefit: the entire amount of home loan interest (without any limit) can be deducted from the rental income as per IT rules. In order to save tax smartly, one should declare property with high rental income as self-occupied. Similarly, while selling a property, these rental income benefits on various properties should be evaluated carefully.

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