Investments that make your money grow are not always meant to achieve short-term goals, sometimes you might be thinking far into the future. Examples of such investments often include those made for retirement, children’s education, children’s marriage and so on. However, not all investments are tax free at the time of maturity; and in some cases, you might have to contend with long-term capital gains taxation at the time of redeeming your investments. Moreover, the definition of what is considered as “long term” with respect to your capital gains is influenced by the type of investment made. In the following sections, we will discuss the long-term capital gains taxation rules applicable to three common types of mutual funds investments – equity mutual funds, non-equity mutual funds and real estate.
Long Term Capital Gains for Equity Mutual Funds
Being primarily invested in equity stocks as well as equity-related investments, these mutual funds (commonly termed as equity funds) are prone to a high degree of volatility due to market ups and downs. Therefore, equity mutual funds simultaneously provide the highest potential for returns as well as the highest level of probable risk to the principal amount invested. Possibly as a result, long term capital gains taxation rules are applicable if units of such a fund are held for a period exceeding 1 year from the date on which the mutual fund units were allotted.
Long Term Capital Gains for Non-Equity Funds
Non-equity funds such as debt funds are considered to be less risky as they are in large part immune to the fluctuations occurring in stock markets. As a result, they also feature a potentially lower ROI as compared to equity investments. Possibly as a result of this, non-equity fund investments are included in the gamut of long term capital gains if the units have been held for a period of 3 years or more from the date those units were originally allocated to the investor. It is noteworthy that holding the investment for over 3 years is not the basis of capital gains. The investor needs to redeem or transfer the mutual fund units for capital gains taxation rules to actually apply.
Long Term Capital Gains for Real Estate Investments
Real estate investments made by an individual are also subject to capital gains at the time of sale. In case of real estate, these rules include the entire gamut of properties such as land, residential property and so on. As per current rules that came into effect from FY 2017-2018 onwards, long term capital gains taxation rules will apply to proceeds of real estate sales provided they were held for a period of at least 2 years from the date of purchase. A shorter period than this would put the sale of the real estate in the gamut of short term capital gains rules.
Role of Indexation in Calculating Long Term Capital Gains
We live in a world powered by deficit financing and ever since the abolition of the gold standard, global growth and economic health is partially signified by steady rate inflation. This however does have a side-effect – the value of money decreases over time as a result of inflation i.e. Rs. 1000 today can be used to purchase more goods today than say 5 years in the future. For example my first bicycle was worth Rs. 1000, while the same bike today i.e. 20 years later would cost me around Rs. 5000, if not more. Thus even if you invested Rs. 1000 today and received Rs. 1100 after 5 years, you might actually end up with a loss instead of a profit due to the impact of inflation. The process of indexation was introduced to provide adjusted values to maturity amounts of investments based on the applicable inflation rates during the investment period. Indexation benefits are available on various long term investments including debt funds and real estate.
Taxation Rules for Long Term Capital Gains of Equity Funds
As long as you have held your equity mutual fund investments for a period exceeding 1 year from the date of unit allotment, long term capital gains taxation rules will apply. At present, the redemption or switch of such units will generate tax free returns because the capital gains tax in such cases is currently zero. However, losses incurred in case of such a sale can be adjusted against long term capital gains generated from other sources.
Taxation Rules for Long Term Capital Gains of Non-Equity Funds
Non-equity mutual funds such as debt funds and hybrid funds come into the purview of long term capital gains only if the units being switched or redeemed have been held by the investor for a period of 3 years or more from the date units were allotted. Indexation benefits are also applicable in case of capital gains obtained through redemption or switch of such non-equity fund units. In case indexation benefits are not availed, the applicable tax rate is 10% of capital gains realised, while the long term capital gains tax rate is 20% with indexation benefit.
Taxation Rules for Long Term Capital Gains of Real Estate
If an investor has held the real estate investment for 2 years or more since the date of purchase, long term capital gains taxation rules will be applicable. In case of real estate too, the final value at the time of sale may be subject to indexation which takes into account inflation as well as costs incurred for improvement of the property (if applicable). The applicable tax rate after indexation in case of real estate is 20% of realised gains similar to the case of non-equity mutual funds. In case a loss is incurred through such a sale, it can be offset against long term capital gains generated from other sources.
Mutual Fund Dividends vs. Long Term Capital Gains
If an investor opts for the dividend option in case of mutual fund investments, no capital gains taxation rules apply. The reason being that all dividends earned from mutual funds though considered to be profits are beyond the purview of capital gains as no redemption or switch has occurred in lieu of the payout. However, the mutual fund house does have to pay a tax, the “dividend distribution tax”, which is payable directly to the government when a dividend payout is declared. This tax is included in the expense ratio of the mutual fund and passed on to the investors by the fund house.