June 07 , 2012
If your investments grow in value, and you sell off or move them around, the government steps in to collect a share of the pie. This tax, on the increase in value your investments have seen, is called capital gains tax.
The computation of the gains and tax can get complicated sometimes, but the broad thumb rule to remember is that the government currently favours:
- Longer term investments over short term ones
- Equity investments over real estate or debt ones
It taxes them appropriately.
Capital gains treatment of different assets
Indian listed equities, whether you invest directly or through mutual funds, enjoy the best tax rate today, as seen in the ready reckoner. In case of mutual funds, any fund having over 65% of its portfolio in equities is given this preferential treatment. In addition to the other benefits of equity investing for the long term, this is another!
2. Gold and real estate
In case of gold and real estate, long term is anything greater than three years. In case of residential real estate, the government provides one exemption from long term capital gains tax. Say you have recently sold your residential property and are liable to pay long term capital gains tax. You can avoid this if:
- You buy another residential real estate within a year of selling this property, or
- You buy bonds of Rural Electrification Corporation (REC) or National Highway Authority of India (NHAI) within 6 months
We would not recommend the second option, since the yield on these bonds is poor (5.5%-6%), it is taxable, and there is a lock-in of 3 years. You might as well pay the capital gains tax than hold these bonds!
One important fact to remember is that interest (from deposits, bonds, etc) is not considered to be capital gains. It is treated as income for the purpose of computing tax. Capital gains tax rates do not depend on your overall income level, but income tax rates do. So if you are in the higher income group, you would find income tax rate higher than the capital gains tax. So, if possible, you would rather convert interest income into capital gains. One way to do this is through mutual funds.
3. Debt funds
Another interesting thing to note is that in case of debt funds, dividends are taxed irrespective of holding period, while capital gains tax depends on holding period. It so happens that the dividend tax rate is less than the short term capital gains tax rate, but more than the long term one. Thus, if investing for greater than 1 year, it makes sense to go for the Growth Option and avoid dividends. If investing for less than 1 year, go for Dividend Reinvestment Option and reduce the capital gains.
The coming of the Direct Tax Code (DTC) is expected to bring several changes to taxation, including the capital gains tax. However, since many of these proposals are being debated and modified, there is no clarity on the final shape of the Code yet. Thus, in the current discussion, we have stuck to the current prevailing tax laws and not considered the DTC.