If you have sold real estate, after a two-year holding period, you may have incurred a long-term capital gain. This is ordinarily taxed at 20% with the benefit of indexation. However, you can reduce the tax you have to pay by reinvesting the proceeds in Section 54EC bonds. These bonds are issued by the National Highways Authority of India (NHAI) and Rural Electrification Corporation (REC), both of which are public sector bodies. The deduction under these bonds is not available if you have sold your property within two years of purchase (short-term capital gain).
You can invest up to Rs 50 lakh in these bonds to get the deduction. At a 20% tax rate (without applying indexation), this will save you about Rs 10 lakh in tax. Typically, due to indexation, the tax saving will be lower. Where the asset is jointly owned, both partners will get separate limits of Rs 50 lakh for their share of the gains, effectively doubling the limit to Rs 1 crore.
The 54EC deduction has been restricted by Budget 2018 to real estate only, while prior to this, long capital gains from the sale of any long-term capital asset could have been set off against investing in section 54EC bonds. Thus gains on unlisted bonds, shares or debt mutual funds or even equity mutual funds cannot get the benefit of this deduction. Also, you cannot exit from these bonds within five years of purchase. This was earlier three years but has been extended by Budget 2018. Note, however, that the five-year lock-in and also the exemption coverage will go into effect on 1st April 2019 only rather than in the coming financial year.
Section 54EC bonds currently carry an interest rate of 5.25%. This interest is taxable. In other words, if you are in the 30% tax bracket, you will get an effective interest rate of 3.67% per annum.
- If you have sold a residential house, you can reinvest the proceeds of your sale in another house under Section 54. However, this exemption is limited to one house and cannot be used for the purchase of multiple houses. You must reinvest the gains, one year before the sale and up to two years after the sale of your house (you get three years if you are constructing the property).
- If you have sold land (other than a residential house), you can reinvest the proceeds of your sale in a residential house under Section 54F. However, the condition here is that you should not have owned more than one house (except for the one you have sold) at the time of sale. You have to purchase or construct the new house, one year before the sale of the capital asset or within three years after the sale.
- You can pay off the tax and invest in mutual funds. However because mutual funds do not get a tax deduction, you would need a pre-tax return of about 10.3% for your money to grow to the same size as it would grow with the bonds. The long-run return on equity is assumed to be 12% but this is by no means guaranteed. Let’s take the example of an index fund. The Niftybees ETF (which is the best approximation for the Nifty Index) delivered a 5-year rolling annualised return of 13.68% on average. Its maximum return was 42.80% and minimum return was -0.27%. A five-year rolling return computes the five-year returns from each day of the year approximately ten years ago. The last data point it examines is exactly five years ago. In other words, investing at the best point of time in the past ten years would have got you 42.80% annualised and investing at the worst point of time would have got you -0.27% annualised. On the other hand, mutual funds, whether debt or equity do not have lock-ins and give you the advantage of flexibility. All this makes the choice between the bonds and mutual funds a very complex one.
- You can pay off the tax and invest in other taxable bonds, FDs or debt mutual funds. However as mentioned above, you would need, at a minimum, a pre-tax return of 10.3% to make up for the lack of deduction. This is highly unlikely in instruments like FDs or taxable bonds in the current interest rate scenario.