What are Capital Gains: Definition, Types and Calculation

Capital gains are essential for anyone involved in buying and selling assets. They represent your profit when you sell property, stocks, or mutual funds for more than you pay. 

Understanding capital gains can help you make smarter investment choices and save on taxes. In this blog, we’ll break down what capital gains are, the different types, how to calculate them, and the tax exemptions available

Understanding Capital Gains

Capital gains refer to the profits earned from selling an asset at a higher price than its purchase cost. It represents the additional money gained through successful investments, playing a vital role in wealth accumulation. These gains are pivotal in investment strategies as they contribute significantly to increasing overall financial assets.

For example, imagine you bought a piece of land for ₹5 lakhs. After a few years, you sell this land for ₹ eight lakhs. The ₹ three lakhs you made over the original price is your capital gain.

Types of Capital Gains

Capital gains are divided into two main types: short-term and long-term. The difference between these types depends on how long you hold an asset before selling it. 

Understanding these categories is important because they are taxed differently. Let’s explore each type in more detail.

Short-Term Capital Gains

Short-term capital gains are the profits realised from selling an asset that has been held for a brief duration, typically within one year of its acquisition.

For instance, if you buy stocks worth ₹50,000 and sell them for ₹60,000 within six months, the ₹10,000 profit is a short-term capital gain.

The asset must be sold within 12 months of purchase to be classified as a short-term capital gain. This rule applies to most assets, such as stocks, bonds, and mutual funds. Real estate has a different criterion: the holding period must be less than 36 months for the gain to be considered short-term.

Long-Term Capital Gains

Long-term capital gains are the profits earned by selling an asset that has been held for an extended period, typically exceeding one year.

For example, if you buy a piece of land for ₹5 lakhs and sell it for ₹8 lakhs after four years, the ₹3 lakhs profit is a long-term capital gain.

For an asset to be classified as a long-term capital gain, it must be held for more than 12 months before being sold. 

In contrast, real estate requires a holding period of more than 36 months for the gain to qualify as long-term, whereas assets such as stocks and mutual funds generally adhere to the one-year holding rule for long-term capital gains.

Calculation of Capital Gains

Calculating capital gains is straightforward if you know the proper steps. Let’s break it down so you can easily understand how to do it.

Steps to Calculate Capital Gains

1. Determine the Sale Price: This is the amount you sold the asset for.
2. Find the Purchase Price: This is the amount you originally paid for the asset.
3. Calculate the Gain: To determine your capital gain, subtract the purchase price from the sale price.
4. Adjust for Costs: Include any expenses related to buying and selling the asset, like brokerage fees or improvements made to the property.

Example Calculation

Let’s say you bought some stocks for ₹20,000. After two years, you sold them for ₹30,000. Here’s how you calculate the capital gain:

1. Sale Price: ₹30,000
2. Purchase Price: ₹20,000
3. Initial Gain: ₹30,000 – ₹20,000 = ₹10,000

If you paid ₹500 in brokerage fees while selling the stocks, you can adjust your gain:

4. Adjusted Gain: ₹10,000 – ₹500 = ₹9,500

So, your capital gain is ₹9,500.

Factors Affecting the Calculation

1. Holding Period: Whether the asset is short-term or long-term affects the calculation and the tax rate.
2. Expenses: The purchase and sale costs, like brokerage fees, can reduce your gain.
3. Improvements: For real estate, any improvements made to the property can be added to the purchase price, reducing the gain.
4. Indexation: For long-term gains, especially in real estate, you can adjust the purchase price for inflation, reducing the gain further.

Tax Exemption on Capital Gains

There are ways to save on taxes in India when you profit from selling assets. The government offers certain exemptions on capital gains, especially if you reinvest your earnings in specific ways. Look at the main tax exemptions available under Section 54 and Section 54F of the Income Tax Act.

Section 54

Section 54 offers a tax exemption on capital gains from selling a residential property, such as a house or apartment. To benefit from this exemption, the profit must be reinvested in another residential property.

• Eligibility: The exemption applies if you sell a residential property and buy another one within a specified period.
• Timeframe: You must buy the new property either one year before or two years after the sale of the old property. Alternatively, you can construct a new house within three years of selling the old property.
• Conditions: The new property must be in India, and the exemption is only for individuals and Hindu Undivided Families (HUFs).

For example, if you sell your house and make a profit of ₹ 10 lakhs, you can avoid paying tax on this profit if you buy another house worth ₹10 lakhs within the specified period.

Section 54F

Section 54F provides a tax exemption on capital gains from selling assets other than residential property, such as stocks or land. The profit must be reinvested in buying a residential property.

• Eligibility: You won’t have to pay taxes on the profit if you sell something other than a home and use all the money from the sale to buy a new home.
• Timeframe: Similar to Section 54, you must purchase the new residential property one year before or two years after the sale or construct a new house within three years.
• Conditions: You must not own more than one residential house (other than the new one) on the date of transfer of the original asset, and you should not buy or construct another residential house (other than the new one) within two years or three years, respectively.

For example, if you sell land and profit from ₹15 lakhs, you can save on taxes by using this ₹15 lakhs to buy a new house within the specified timeframe.

Assets Eligible for Capital Gains 

Conclusion 

Understanding capital gains helps you make better investment decisions and plan for tax savings. Knowing the types, calculation methods, and tax exemptions can maximise your returns and reduce tax liabilities.