Capital gain refers to the profit or gain made by an individual or entity on selling an asset such as property, stocks, mutual funds, bonds, or any other investment. It is calculated as the difference between the purchase price (also known as the cost of acquisition) and the asset’s sale price (also known as the consideration received). The difference is considered a capital gain if the sale price is higher than the purchase price. Capital gains are subject to taxation in most countries, and the tax rate may vary based on the duration for which the asset was held and other factors.
There are two types of capital gain: long-term (LTCG) and short-term (STCG).
Long-Term Capital Gain
A long-term capital gain (LTCG) is a profit made from the sale of an asset that has been held for more than 36 months (for an immovable property like land or building) or more than 12 months (for all other assets such as shares, mutual funds, etc.).
Advantages of Long-Term Capital Gain:
- Lower tax rate: The tax rate on long-term capital gains is lower than on short-term capital gains. As per the current tax laws, long-term capital gains on listed equity shares and equity-oriented mutual funds are taxed at 10% (if gains exceed Rs. 1 lakh), while for all other assets, the tax rate is 20% (plus applicable surcharge and cess). This makes it more beneficial for taxpayers to hold their assets long-term and avail of the lower tax rates.
- Inflation adjustment: In the case of long-term capital gains, taxpayers can adjust the cost of acquisition of the asset for inflation using the Cost Inflation Index (CII). This helps to reduce the taxable gains and thus lowers the tax liability.
- Indexation benefit: Indexation benefit can be availed by taxpayers for long-term capital gains on non-equity assets. Indexation means adjusting the asset acquisition cost for inflation using the CII, which results in a higher acquisition cost and thus reduces the taxable gains.
Disadvantages of Long-Term Capital Gain:
- Holding period requirement: To benefit from lower tax rates on long-term capital gains, the asset must be held for a minimum period of 12 months (or 36 months for the immovable property). This may only sometimes be feasible, especially if taxpayers must liquidate their investments for emergencies.
- Delayed returns: Holding an asset for the long term may only sometimes provide the expected returns as it depends on various factors such as market conditions, economic factors, etc. Moreover, the returns from long-term investments may take longer to materialize compared to short-term investments.
Example Long-Term Capital Gain:
Suppose Mr. X bought 100 shares of ABC Ltd. on 1st January 2018, for Rs.500/- per share. On 1st January 2021, he sold these shares for Rs.800/- per share. The cost of acquisition for these shares after indexation using the Cost Inflation Index (CII) for the relevant years comes to Rs.612/- per share.
The long-term capital gain, in this case, will be Rs.188/- per share (800 – 612). Since the gain exceeds Rs.1 lac, Mr. X will have to pay tax at 10% on the LTCG of Rs.18,800/- (100 shares x Rs.188/- per share).
In this example, the long-term advantage of holding the shares is that Mr. X can benefit from indexation, which reduces the taxable gains. The disadvantage, however, is that he had to hold the shares for more than 12 months to avail of the lower tax rate on LTCG, which may only sometimes be feasible in some situations.
Short-Term Capital Gain
A short-term capital gain (STCG) is a profit made from the sale of an asset that has been held for less than 36 months (for an immovable property like land or building) or less than 12 months (for all other assets such as shares, mutual funds, etc.).
Advantages of Short-Term Capital Gain:
- Quick returns: Short-term investments can provide quick returns compared to long-term investments. This is because the holding period for short-term investments is shorter, and investors can take advantage of market movements in a shorter period.
- Flexibility: Short-term investments provide more flexibility to investors as they can easily liquidate their investments to meet their financial requirements or take advantage of new investment opportunities.
- No holding period requirement: There is no minimum requirement for short-term capital gains. Therefore, investors can sell their assets at any time without having to worry about the holding period.
Disadvantages of Short-Term Capital Gain:
- Higher tax rate: The tax rate on short-term capital gains is higher than on long-term capital gains. As per the current tax laws, short-term capital gains on listed equity shares and equity-oriented mutual funds are taxed at 15%, while for all other assets, the tax rate is as per the applicable tax slab rates. This makes it more beneficial for taxpayers to hold their assets long-term and avail of the lower tax rates.
- No inflation adjustment: In the case of short-term capital gains, taxpayers cannot adjust the cost of asset acquisition for inflation. Therefore, the entire gain is subject to tax, which can result in a higher tax liability.
Example Short-Term Capital Gain:
Suppose Mr. Y bought 100 shares of XYZ Ltd. on 1st January 2021, for Rs.500/- per share. On 1st July 2021, he sold these shares for Rs. 600 per share.
The short-term capital gain, in this case, will be Rs.100/- per share (600 – 500). Since the gain is short-term, Mr. Y will have to pay tax at 15% on the STCG of Rs.10,000/- (100 shares x Rs.100/- per share).
In this example, the advantage of holding the shares for the short term is that Mr. Y can quickly realize the gain on his investment. The disadvantage is that the tax liability on short-term capital gains is higher, and he cannot adjust the acquisition cost for inflation.
Capital gain refers to the profit or gain made by an individual or entity on the sale of an asset. The tax rates for STCG and LTCG are different, with STCG attracting a higher tax rate than LTCG. Taxpayers need to understand the rules and regulations related to capital gains and plan their investments accordingly to maximize their gains and minimize their tax liability.