All you wanted to know about capital gain

ou landed yourself a job and now want to venture into the world of shares and mutual funds. Maybe even property. Well, what you buy one day, you will end up selling the next, right?

And that means either a capital gain or loss. There is no avoiding it.

Here is to demystifying this tax concept which affects us all.

When you sell any asset you own (house, land, shares, mutual fund units, gold, debentures, bonds) and you make a profit on the sale, it is known as capital gain. The tax you pay on this profit is called the capital gains tax.

If you make a loss (you sell at a lower price than you bought it), you incur a capital loss.

What are the types of capital gains?

Depending on how long you held the asset, the capital gain is classified either as short-term or long-term.

Short-term capital gain: If you sell the asset within 36 months from the date of purchase (12 months for shares or mutual funds)

Long-term capital gain: If you sell the asset after 36 months from the date of purchase (12 months for shares or mutual funds)

How is short-term capital gain taxed?

Very simple. A short-term capital gain is added to your total income. Depending on which tax bracket you fall under, you will be taxed.

How is long-term capital gain taxed?

Tax on long-term capital gain (other than shares and mutual fund units), is more complicated. This is because inflation is taken into account. This is good because it reduces the amount of capital gain and the amount you end up paying as tax.

Let's say Mr Mani purchased a house of Rs 2,50,000 (Rs 250,000) on June 20, 1996. He sells it on January 20, 2005, for Rs 4,50,000 (Rs 450,000). Since the house was sold over 36 months after being bought, the capital gain will be long term.

First, you calculate the Cost Inflation Index. These indices are fixed and declared by the Central Government every year (see table below). This is called indexation.

Cost inflation index:
Index of the year it was sold / index of the year it was bought
2004-05 index / 1996-97 index
480/305 = 1.57377

Indexed cost of acquisition
= Buying cost x CII
= 250000 x 1.57377
= 3,93,443

Long term capital gain
= Selling price – Indexed cost 
= 4,50,000 – 3,93,443
= Rs 56,547

Tax payable will be 20% of Rs 56,547 ie Rs 11,310. (Plus surcharge of 10% if applicable)

Cost Inflation Index for the various financial years

How is long-term capital gain taxed on shares and mutual funds?

You can pay the tax on long term capital gains on shares and mutual funds either at the rate of 20% or 10%. The choice is yours. 

This is how it is done.

Let's say that Mr Mani purchased 4,000 shares on July 27, 2003 and paid Rs 10 per share. He sold them on September 15, 2004 for Rs 12 per share.

Since the investment is held for more than 12 months, the capital gain will be long-term.

If he computes with indexation using the above method, his capital gain will amount to Rs 6,532.

He will have to pay a tax of 20% on Rs 6532, which is Rs 1,306.

If he computes without indexation, this is the way it is done. 

Sale proceeds = Rs 48,000 (4,000 shares x Rs 12)
Cost of acquisition = Rs 40,000 (4,000 shares x Rs 10)
Long-term capital gain = Rs 8,000
Tax payable will be 10% on Rs 8,000, which is Rs 800

Capital loss?

That's right. Sometimes, you do not make a profit. You sell at a higher rate than at what you bought. This is a capital loss. You can then set off this loss against a gain.

~ Long-term capital loss can be set off only against a long-term capital gain.

~ Short-term capital loss can be set off against any type of capital gain, long-term or short-term.

You need not incur the loss and gain in one single year. A long-term capital loss can be carried forward for eight years to be set off against a long-term capital gain.

A short-term capital loss can be set off against any income under the head capital gains (whether short-term or long-term) and can also be carried forward for eight years.

In both cases, these eight years start after the financial year when the loss is incurred.