If you have sold your debt funds at a profit, you will be liable to pay capital gains tax. If your holding period is 3 years or less, this is characterised as short term capital gains (STCG) and no exemption is available to you. However if your holding period is more than three years, the gains are characterised as long term capital gains (LTCG) and you are taxed at 20% of the gains. You are also given the benefit of indexation. Indexation takes into account inflation to reduce your tax liability. In addition to indexation, there are two other sections of the Income Tax Act, 1961 that give you relief from tax on capital gains on all assets. Note that the third section dealing with capital gains exemption (Section 54 of the Income Tax Act) only applies to gains on house property. The applicable sections are:
Section 54F grants exemption to the gains on any capital asset (including debt funds) if they are invested in a residential property. A number of conditions are attached:
- You cannot already own more than 1 residential property at the time of transfer
- You have to invest the redemption proceeds within 2 years after transfer or 1 year before transfer if you are buying a new property. If you are constructing a house, you get one additional year. Here you get to invest the redemption proceeds within 3 years after transfer or 1 year before transfer if you constructing a new property.
- If your property is not purchased/constructed within 1 year of transfer, you have to place the money in a specially designated capital gains account at a bank.
- If you sell the property within 3 years of purchase, the exemption is reversed.
- The property must be bought in your own name to avail of the exemption.
- If you do not invest all the redemption proceeds, the exemption is given proportionately. For example, assume that you sell mutual funds purchased for Rs 50 lakh for Rs 80 lakh, incurring a gain of Rs 30 lakh. You invest Rs 40 lakh (half the redemption amount) in the purchase of a residential flat. Since you have invested half the redemption proceeds in the sale of a property, you will get exemption half your total gains (0.5*Rs 30 lakh = Rs 15 lakh).
Section 54 EC
This exemption was earlier given to gains from any capital asset including debt funds, just as is the case with Section 54 F. It allowed you to claim exemption on the gains in debt funds by reinvesting the proceeds in the bonds of National Highways Authority of India (NHAI) and Rural Electrification Corporation (REC). These bonds carried an interest of around 3.5% which was taxable. They had a tenure of 3 years. However Budget 2018, restricted the scope of this section to gains from land and real estate and it increased the tenure of these bonds to 5 years. As a result, you can no longer take the benefit of this section in claiming relief on your gains in debt mutual funds.
How indexation works
Last but not least, you can use indexation to reduce your tax liability on gains in debt mutual funds. Indexation takes inflation into account The taxable gain is reduced after factoring the Cost Inflation Index (CII) published by the Income Tax Department every year.
For example assume that you buy a debt fund in 2010 for Rs 100 and sell it in 2014 for Rs 150. Since you have sold it after three years, the gain is long term and a tax of 20% with indexation will apply. The Cost Inflation Index (CII) in FY 10 was 148 and the CII in FY 14 was 200. As a result your purchase price for tax purposes will rise to 200/148 = 135 and your taxable gain will be 150 – 135 = 15. The tax payable will be 20% of 15 = Rs 3. Hence even though you have made a gain of Rs 50, your actual tax is only 3 after applying indexation.