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The housing tax trap

A N Shanbhag

Section 54 of the Income Tax Act gives exemption from tax on capital gains arising out of sale (or transfer) of a residential house, whether it is self-occupied or not.

However, a few conditions must be adhered to: the assessee must purchase a residential house before one year or two years after the date of sale or must construct a house within three years. If only a part of the amount required is used, the exemption would be pro-rata and the excess will be chargeable to tax.

Two points should be carefully noted:

• For construction, there is no restriction on the commencement date of construction. It could be even more than 20 years.

• The assessee need not apply the amount from the sale proceeds for purchasing another residential house. For instance, he can take a loan for the purchase or construction and use the sale proceeds for investment elsewhere, if it is beneficial for him to do so.

Though Section 54F has similar stipulations in respect of capital gains arising out of assets other than residential houses, there are three differences:

• Section 54F is available if the assessee is not an owner of more than one property on the date when he sells an asset and earns long-term capital gains. Section 54 has no such stipulation.

• Section 54F requires reinvestment of the net consideration (sale value less expenses), whereas Section 54 is content with reinvestment of only the amount of capital gains.

• Under Section 54, the assessee is required not to sell the newly-acquired property within three years from the date of its purchase or construction. If this condition is not satisfied, the cost of the new asset is to be reduced by the amount of long-term capital gains exempted from tax on the original asset and the difference between its sale price and such reduced cost will be chargeable as short-term capital gain earned during the year in which the new asset is sold.

In the case of Section 54F, the assessee is also required not to sell the new property within three years (same as the condition of Section 54). Over and above this, he should not purchase within one year (note that this period is one year and not two years) or construct within three years, after the transfer of the original asset, another residential house.

If these conditions are not satisfied, there is a penalty; different from that of Section 54. The capital gain originally exempted shall be treated as long-term capital gain of the year in which the house is sold or another residential house is purchased or constructed.

It is this difference in the penal provisions that creates confusion. There is no sense in imposing different punishments for the same offence. In the case of Section 54, how can the character of capital gains suddenly change to short-term?

Here is an example to elucidate the difference between the two: An assessee in the 30 per cent marginal tax zone has earned long-term capital gains on sale of a financial asset. (See Table 1)

Table 1

Asset purchased in FY 90-91	5,00,000
Sale Value in FY 99-00	15,00,000
Indexed cost = (5,00,000 * 389)/182#	10,68,680
Long term gains	4,31,320

#Cost Inflation index of 1990-91 is 182 and cost inflation index of 1999-2000 is 389

Now, suppose a new residential house costing Rs 400,000 is purchased within two years or constructed within three years. The tax liability (ignore surcharge) on long-term capital gains are given in Table 2.

Tabel 2

Asset sold was a residential house
Long term capital gains	4,31,320
Exemption u/s 54	4,00,000
Tax payable on	31,320
Tax thereon @ 20%	6,264
Asset sold was not a residential house
Long term capital gains	4,31,320
Exemption u/s 54	1,15,020
Tax payable on	3,16,300
Tax thereon @ 20%	63,260

Take the situation where the assessee sells the new house within three years, say in FY 2001-02 for Rs 1.6 million. (See Table 3)The assessee has to pay Rs 96,996 less if the capital gains had arisen from assets like shares, jewellery, etc., rather than a residential house.

Table 3

Asset sold was a residential house
Sale proceeds of new house	16,00,000
Actual cost of new house	15,00,000
Less: Exemption claimed in FY 1999	4,00,000
Deemed cost of new house	11,00,000
Short-term capital gains in FY 2001-02	5,00,000
Tax thereon @ 30%	1,50,000
Asset sold was not a residential house
Exemption claimed in FY 97-98 deemed as long term capital gains in FY 2001-02	1,15,020
Tax thereon @ 20%	23,004 (a)
Sale proceeds of new house	16,00,000
Actual cost of new house	15,00,000
Short-term capital gains in FY 2001-02	1,00,000
Tax thereon @ 30%	30,000 (b)
Total tax (a+b)	53,004

One of my readers, Captain Shelar, sold a house situated in a city and purchased a more spacious house in the suburbs. After moving in he found that his next-door neighbour was a prostitute.

He decided to move out immediately but found that he was trapped. The shift would rob him of the exemption as well as the benefit of tax rebate under Section 88, which requires a lock-in of five years.

I strongly feel that the authorities should allow him to recompute his long-term capital gains by using the cost and date of acquisition of the very first house he sold and the reinvestment in the new house, if he shifts within three years. This method would be consistent with the provisions relating to gifted properties.

Whenever a donee sells a gifted asset, he is required to use the cost and date of acquisition at which the donor had held the asset. Why do the tax authorities not standardise the norms?

In any case, fair or otherwise, this is indeed quite confusing and complex. No legislation should be this complicated.

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