Understanding Long term and Short term Capital Gains
With complex capital gains tax structure, it's wise to first make yourself aware on the net returns i.e. post tax returns you will earn, whenever you intend to make any investment. This article shows how long term and short term capital gains are derived and how it can help in reducing your taxability.
There are various asset classes like equity, debt, gold, & real estate where you invest according to the time horizon of your goals and risk appetite. The gains from these investments are termed as capital gains and taxed differently. Since any tax liability impact your returns from the investment, it's important to have awareness on the net gains you will receive.
The capital gains from above mentioned asset classes is classified as long term or short term based on the holding period of investment. For e.g. in real estate, if you have held the asset for more than 3 years it is treated as long term. Contrary to this in equities, investment for more than a year is treated as long term.
Here are some calculations to show how long term and short term capital gains are derived and how it can help in reducing your taxability:
1. Long term Capital Gains: A long term capital gain arises when you hold any asset for a defined period. This period ranges from one year to three year across different asset classes. The table below shows the holding period for long term gains in various asset classes and the applicable tax rate:
As can be inferred from the data, equities enjoy zero taxability on long term capital gains while in real estate or physical gold investment you have to pay a flat rate. Due to these variations the post-tax returns from these asset classes can vary substantially. There are provisions in income tax to reduce LTCG through indexation or save LTCG tax from some of these instruments by investing it in other alternatives.
Indexation Benefit: Inflation constantly erodes real value of money through rise in prices. Due to this even if your investment have risen four times the purchasing power of money will have went down 50% from the time you made investment. To reduce the impact of inflation on your investment, indexation benefit is provided in calculating long term capital gains. Through this benefit you can adjust your capital gains from inflation by applying an appropriate factor from cost inflation index to the original units.
Here is how indexation benefits works:
Cost of purchasing a property in 2007- Rs 3500000
Cost of selling the property in 2011 - Rs 5000000
Inflation Index- 2007 - 551
2011 - 785
Indexed Purchase cost- 3500000*785/551= Rs 4986388
Long Term Capital Gains= 5000000-4986388 = Rs 13612*
Tax on LTCG= 13612*20%= Rs 2722
Education Cess= 2722*3% = Rs 82
Total Tax on LTCG = Rs 2804
*The non- indexed gain would have been Rs 15 lakh
Thus, the indexation benefit reduces the tax liability substantially which otherwise would have been a huge payout for any investor.
2. Short Term Capital Gains: Investments in any asset class if held for a very short period is taxed as short term capital gains. Except equity, short term gains from other assets is included in investor's income and taxed at slab rate. The data below highlights the taxation structure in case of short term capital gains:
*Education cess of 3% is applicable on all tax rates
This is how short term capital gains are calculated:
Cost of Equity Mutual Funds units bought in 2011- Rs 100000
Price of same units sold after 6 months - Rs 120000
Short Term capital Gains - Rs 20000
Tax Applicable- 20000*15%= Rs 3000
Education Cess - 3000*3%=Rs 90
Total Tax payable= Rs 3090
With complex capital gains tax structure, it's wise to first make yourself aware on the net returns i.e. post tax returns you will earn, whenever you intend to make any investment. This will help in analyzing the amount of wealth creation you will create after paying your tax liabilities.
The author is a Certified Financial Planner and Founder of JS Financial Advisors. You can reach him at firstname.lastname@example.org