Understanding capital gains tax exemption under Section 54

The profit earned from the sale of a house is taxed as a capital gain. Depending on the holding period, the house may be classified as either a short-term or a long-term capital asset.

A tax rate of 20% is levied along with surcharge and cess as applicable if the property is held for 24 months or more, known as long-term. While the gains are taxed at slab rates if held for a short term, i.e for less than 24 months.

Let us say a person wanted to shift his residence due to certain reasons and hence he sold his old house. From the sale proceeds, he decides to purchase another house.

In this case, the objective of the seller was not to earn income by the sale of the old house but to acquire another suitable house. If in this case, the seller was liable to pay income tax on capital gains arising from the sale of the old house, then it would impose a hardship on him. 

Under Section 54 of the Income Tax Act, a seller can av­ail of tax exemption on the capital gain arising from the transfer of a residential house property. This benefit is available only to individuals and Hindu Undivided Families (HUFs).

Further, the asset transferred should be a long-term capital asset, held for at least 24 months. The taxpayer should have purchased the second house within India either one year before the date of sale of the old house or two years after.

If the assessee is constructing a house, then construction expenses incurred within three years from the date of sale of the first house would qualify. 

The exemption under Section 54 will be lower of the amount of capital gain on the sale of residential property or the amount invested in the purchase or construction of a new residential property. Any remaining amount is taxable.

The exemption can be claimed only in respect of one residential house property purchased or constructed in India. If more than one house is purchased or constructed, then, exemption under section 54 will be available in respect of one house only. No exemption can be claimed in respect of a house purchased outside India.

But with effect from Assessment Year 2021-22, the Finance Act, Section 54 has been amended to extend the benefit of exemption in respect of investment made in two residential house properties, provided the amount of long-term capital gain does not exceed Rs 2 crore. This option can be exercised by the taxpayer only once in his lifetime.

The exemption under section 54 is available in respect of the rollover of capital gains arising on the transfer of a residential house into another residential house. However, to keep a check on misuse of this benefit and to ensure it is available only to long-term buyers, restrictions have been put in place.

If a taxpayer purchases or constructs a house and claims exemption under section 54 and then transfers the new house within a period of three years from the date of its acquisition or completion of construction, then the benefit granted under section 54 will be withdrawn.