Capital Gain Exemption Under Section 54 of Income Tax Act, 1961

Section 2(14) of Income Tax Act,1961, defines a capital asset to include any kind of property held by an assessee, whether or not connected with business or profession of the assessee. Capital gain arises on the sale of a capital asset. The capital gain so arisen can be classified as-

1. Long Term Capital Gain
2. Short Term Capital Gain

Section 54 of the Income Tax Act,1961 provides exemption towards Long Term Capital Gain arising on sale of Residential House Property.

What does Section 54 of the Income Tax Act, 1961, say?

As per section 54 of Income Tax Act, 1961 an individual or HUF selling a residential house property can avail tax exemption under the said section for the capital gains, provided the capital gains are invested in purchase or construction of Residential House Property.

What are the conditions to avail exemption under section 54?

1. The assessee should be an individual or HUF.
2. The assessee has transferred a residential house property, which is a long term capital asset.
3. The assessee has within a period of one year before or two years after the date on which the transfer took place purchased one residential house in India or has within a period of three years after the date of transfer constructed a residential house in India.

If all the above conditions are satisfied then, instead of the capital gain being charged to income-tax as income of the previous year in which the transfer took place, it shall be exempted from tax.

With effect from AY 2020-21, the assessee may, at his option, purchase or construct two residential houses in India provided the long term capital gain arising on such transfer does not exceed Rs.2 crore. Such an option may be exercised only once in his/her lifetime.

What is the exemption limit under section 54?

The exemption under section 54 of the Income Tax Act, 1961 will be lower of:

1. The long term capital gain amount arising on transfer of residential house property or
2. The amount invested in the purchase or construction of residential house property. Any balance amount of capital gain shall be taxed accordingly.

For example-

Mr X sells his residential flat and a long term capital gain Rs 60,00,000/- has arose

With the proceeds of the sale, he purchases another villa for Rs 45,00,000/-

Capital Gains will be computed as follows

The exemption will be lower of the Capital Gains (Rs 60,00,000) or investment in new property (Rs 45,00,000), so the exemption will be Rs 45,00,000.

Provisions Related to Transfer of Property u/s 54

Under Section 54 of the Income Tax Act says that, if you have purchase / constructed a house and you sold that new house within 3years, then the exemption claimed under Section 54 becomes taxable in the year of sale of the new property.

In this case, let’s consider 2 different scenarios when new house is sold within 3 years of purchase

Case 1 :  When the new house is sold within three years and purchased a new house which is less than the capital gains, the cost of acquisition for tax purposes becomes Nil and the balance amount becomes taxable which leads to an indirect increase in taxable capital gains.

For Example :

Mr. Rajesh sold a property on June 22 from which he gained Rs. 25,00,000. After the sale of property he purchase a new property on Nov 22 amounting to Rs. 18,00,000.  Again the new residential property which he purchased on Nov 22 sold the same on December 2023 Rs.40,00,000.

Capital Gains made in 2022:

Capital Gains made in 2023:

Case 2 :  When purchased of a new house is more than the capital gains which is received from selling a old property, then capital gains are exempted due to the reinvestment. However, when the new property is sold within 3 years, then the capital gains will be taxable.

For Example :

Mr. Rajesh sold a property on Jul 22 from which he gained Rs. 30,00,000. After the sale of property he purchase a new property on Nov 22 amounting to Rs. 35,00,000.  Again the new residential property which he purchased on Nov 22 sold the same on Oct 23 Rs.45,00,000.

Capital Gains made in 2022:

Capital Gains made in 2023:

Consequences of Transferring the New House Property Within 3 years

When new house is sold within three years of purchasing or constructing it, the exemption under Section 54 will be withdrawn and you have to pay tax on the capital gains that were previously exempted.

When the cost of the new house is less than the capital gains from selling the original house, the capital gains becomes remain exempted, but the transfer of the new property becomes taxable, with the cost of acquiring the new asset considered zero.

What is a Capital Asset?

A capital asset means any kind of property which is owned by an individual, whether it is related to business or not. It can be either -

• Movable/ Immovable - Land, Building, A house.
• Tangible/Intangible - Vehicles, Goodwill, trademarks.
• Fixed - Machinery, Jewellery.

What is Capital Gains Account scheme?

The Capital Gains Account Scheme refer to an account which allows individuals to deposit the amount received from the sale of a property to defer tax liability if they immediately doesn’t want to reinvest in another property. 

Impact of the Finance Act 2023 on Section 54 of the Income Tax Act

Previous rule regarding capital gain exemption under Section 54 - There was no limit on the capital gain exemption when investing in a new residential property.

New rule regarding the maximum exemption under Section 54 - the maximum exemption is capped at Rs. 10 crore with effect from the Financial Year 2023-24.

When should the assessee deposit the capital gain amount in the Capital Gain Account Scheme?

The amount of the capital gain which is not appropriated by the assessee towards the purchase of the new asset made within one year before the date on which the transfer of the original asset took place, or which is not utilised by him for the purchase or construction of the new asset before the date of furnishing the return of income under section 139, shall be deposited by him in the capital gain account scheme before furnishing such return.

What happens if the capital gain amount is not utilized within the time limit for purchase or construction of residential house property?

The unutilized portion of the capital gain amount shall be treated as the income of the previous year in which period of three years from the date of transfer of the original asset expires and shall be taxed as though the income arises in that previous year. The assessee can also withdraw the money in accordance with the terms of capital gain account scheme.