How is Tax On Sale Of Inherited Property Calculated?

Inheritance tax in India was abolished in 1986. There are some discussions in public forums regarding the reintroduction of inheritance tax, especially for high net worth individuals. This serves to reduce wealth disparity in the community, which in India is surely very high.

Meanwhile, we must make do with the status as exists to compute tax on the sale of inherited property. Inherited property is taxable when it is sold by the inheritor. Income due profits from such transactions are treated as Long Term Capital Gains (LTCG).

What is LTCG?

LTCG is a general term that covers income arising from profits accruing from the sale of assets held in possession of the owner for a significant duration of time. Assets in the context of LTCG refers to Real estate, Immovable property, shares, equity-like products etc. LTCG is defined differently for various assets.

LTCG on land or immovable property is applicable when the property is in possession of the owner for at least two years. Till last financial year, it was three but has now been reduced in the current budget. The tax rate is 20% of the profit accrued.

How to Compute Tax on Sale of Inherited Property?

The year of inheritance has no bearing on the tax computation. The profit is computed by deducting the indexed purchase price of the property from the consideration value at which it was disposed.

The indexation is based on the cost inflation index (CII) which was also notified in the current Budget. The CII is computed using 2000-01 as the base year. This implies that purchases prior to the year 2000 will use 100 as the CII value for calculating the indexed cost. The currently applicable CII table is as follows:

An example of tax computation for sale of inherited property is as follows:

Sale Year: 2017

Purchase Year: 2001

Year Inherited: 2012

Sale price or Consideration Value: Rs 25,00,000

Purchase Price: Rs 7,00.000

Purchase Price Index Factor: 272/100= 2.72

Indexed value of Purchase cost: 2.72 x 7,00,000=Rs 19,04,000

Profit: Rs 5,96,000

Tax (@20% of profit): Rs 1,19,200

The sale of the property at the indexed cost i.e. Rs 19,04,000, as in the foregoing case, or less will not invite any tax liability for the transaction.

How to Avoid Tax on Sale of Inherited Property?

The tax on the sale of property, whether inherited or otherwise can be substantial. One can avoid these taxes yet do his patriotic duty to the Nation by invoking the provisions of section 54EC of the Income Tax Act 1961.

Organisations like National Highways Authorities and Rural Electrification Corporation have been authorized by the government to make public issues of infrastructure or capital gains bonds. These Bonds are specifically meant for LTCG and since the investment goes towards building the national infrastructure and national growth, these investments are fully exempt from tax liability up to the extent of Rs 50,00,000.

Infrastructure bonds have a duration of five, ten or fifteen years and are tradeable on the stock exchange. These give returns typically of the order of 5% to 7%. The interest component is taxable in the year of accrual as income in respective tax slab, so is the redemption value, but as LTCG.

In this case, it is nil since the bonds are redeemed at face value. The LTCG provision will apply only if the Bond is sold prematurely at a premium, even then the tax amount is unlikely to be substantial.

In the illustrated example, assume that the tax liability of Rs 1,20,000 is invested in infrastructure bonds say at 6% interest for five years. This will give an annual income of Rs 7,200 per year for five years.

Assuming 30% tax slab, the net annual income will be Rs 5,040. Over five years this will amount to Rs 25,020. At the end of five years on redemption of the bond at par, the value erosion will only be due to inflation. This cash flow can tolerate a CII or indexation factor of approximately 80% (1,20,000/1,45,020=0.82).

This compares well with the period from 2013-14 to 2017-18 (220/272=0.81). For example, take the period 2006-07 to 2010-11 (122/167=0.73). In this case the erosion due to inflation amounts to Rs 32,400 ((1-0.73)x 1,20,000= Rs 32,400).

Adjusting the income accrual of Rs 25,040, the negative difference is of the order of Rs 7,000. This amounts to just about 6% of the investment. The calculation here is simplistic and illustrative, but there are finer points like interest on the annual cash flow which can alter the figures though not substantially.

Predicting inflation is never easy and estimating future indexation value impossible. One may judge based on government policy trends and market trends. Both these are currently positive and encouraging but uncertainties over five years may only be stated probabilistically with an abundant margin of error.

Premature disposal of bonds is also a viable option to address inflation concerns. But in layman terms, there can be little doubt that it is better to lose Rs 10,000 after five years rather than lose Rs 1,20,000 in taxes today.

Other Ways to Save Taxes on LTCG on Inherited House Property

There are other ways to save taxes on LTCG. One is to use the proceeds for part or full payment to buy a house within two Years or construct one within three Years of the tax liability arising.

You may also deposit the amount in the bank on the assurance that the amount will be appropriately invested as per provisions applicable to LTCG within the period stipulated by the prevailing bank rules. Default on this account will result in the bank deducting tax on LTCG.

Tax computation on the sale of inherited property is very akin to that of the sale of immovable assets. It is imperative that the tax liability is well understood. Since the tax amount is generally very substantive, it is best that a suitable investment option be chosen after due care and consideration.