You must pay capital gain tax if you sell movable or immovable assets, such as a house, land, jewellery, shares, mutual funds, etc. The tax rate will apply based on the short- or long-term gains on the assets. The taxpayer must also file an ITR-2 form for income from capital gains. Furthermore, for long-term capital gain, the indexation method will be used to calculate your tax liability, whereas for short-term capital gain, tax is levied on the total gain.

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Indexation helps determine the asset’s value at the time of sale. For instance, it increases the cost value by adjusting it with inflation. So, a higher cost value lowers the capital gain, which reduces the tax liability. However, in the case of a property, it can be relatively easier to find its current value or the inflation-adjusted indexed value as it is on paper. After this, one can invest the capital gain in tax-saving instruments stipulated in the Income-tax Act.

Ways To Save Capital Gain Tax On Property

a) To avoid capital gain tax, you can use the profits from a house sale to buy another house within a year or two or construct a home within three years. These requirements are vital for tax exemption.

b) The new house must be a residential property in India.

c) Furthermore, if the cost of the new house is less than the sale price of the old property, only the remaining amount from the sale proceeds will be taxed if not invested in specific bonds.

So, if you have these grounds, you don’t need to pay capital gain tax. However, there is another way to reduce capital gain tax on property. That is if you can show renovation or construction costs. If you construct a new room or an additional area in your house, you can include these expenses for tax deduction from the sale proceeds of your old property.

Says Aastha Dhowan, partner at tax firm N.A. Shah Associates, “Under the I-T Act, a person can claim indexation benefit on the acquisition cost and cost incurred for property improvement. Capital expenditure incurred for renovation leading to property improvement, for example, increasing a floor or a room, can be considered a cost of improvement.

“Indexation allows for adjustment of the purchase price and improvement costs according to the inflation index, thereby reducing the taxable capital gains. This is particularly beneficial in long-term capital gains calculations, where the holding period exceeds 24 months. What gets covered under the term ‘renovation’ will have to follow judicial parlance and not common terminology”.

However, what most people may not know is that they must show the bills for house renovation, construction, etc., as proof to claim improvement costs from capital gains. This expenditure can be indexed to determine the property’s current value or the final acquisition cost. This step will bring down the capital gain and, in turn, the tax liability. But if you include the cost without proof in ITR, it could attract a penalty in case the Income Tax Department issues a notice. So, it’s vital to keep all the bills and documents related to the property improvement handy.

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How Can Improvement Cost Reduce Capital Gain?

Dhowan explains this with an example. Say, a person (now 63) bought the property in 2004 for Rs 10 lakh and sold it in 2024 for Rs 65 lakh. In this case, the capital gain of Rs 34,20,354will be taxed as Long-Term Capital Gains (LTCG). Here is the calculation:

• Full value of consideration – Rs 65,00,000
• Indexed cost of acquisition – Rs 10,00,000/113*348 = Rs 30,79,646
• Capital gain (LTCG) – (Rs 65,00,000 – Rs 30,79,646) = Rs 34,20,354

But, in the same example, if he had constructed a floor (three rooms) on the property in 2009 for around Rs 10 lakh, this could have significantly reduced his capital gain tax liability:

Indexed cost of improvement: Rs 10,00,000*348/148 = Rs 23,51,351

Total indexed cost = Indexed cost of acquisition + indexed cost of improvement

So, total indexed cost (Rs 30,79,646 + Rs 23,51,351) = Rs 54,30,997

*Cost Inflation Index (CII) for 2004-05: 148, 2023-24: 348, 2009-10: 148. 

Revised Capital Gain:

• Capital Gain = Full value of consideration−Total indexed cost
• Capital Gain/(Loss) = Rs 65,00,000 – Rs 54,30,997 = Rs 10,69,003

This shows his capital gain has significantly reduced from Rs 34 lakh to Rs 10 lakh.

Indexation Benefit:

Indexation benefit is applied only to long-term capital gains. As per income tax rules, if you profit from selling land or a house property you owned for over 24 months, gold jewellery for more than 36 months, and shares and equity mutual funds for over 12 months, it will be considered a long-term capital gain.

Dhowan emphasises maintaining records/bills for home construction as proof to claim improvement costs later. It will help you audit, avail indexation benefits, and accurately compute capital gains. Failing to provide proper evidence of the expenses could attract income tax notice, penalty and legal troubles for underreporting or misreporting income to the authorities.