Short Term Capital Gains Tax Vs Long Term Capital Gains
To have separate tax treatment for individuals who invest to protect their savings and those who make the investment as a way to generate income, the capital gains on selling shares have been divided into two groups for tax purposes. Long-term capital gains are any earnings from shares sold after being held for longer than a year. Short-term capital gains are any earnings from the sale of shares held for less than a year.
Taxation On Short Term Capital Gains
Short term investors certainly gain a little more than long term investors because they are investing their money. The capital gains of the short-term investors are taxed at a fixed rate of 15%.
However, you are permitted to deduct that sum from the capital gains in order to reduce your tax liability if you had any out-of-pocket costs when you bought or sold the shares, such as brokerage. So, the formula for calculating the tax on short-term capital gains would be: Selling Price - Stock Purchase Price - Purchase or Sale Costs.
The amount that must be paid to the tax authorities will be 15% of the capital gains determined by this calculation. Long-term investors, however, are approached differently in matters of tax on capital gains from selling your shares.
Taxation on Long-Term Capital Gains When You Sell Your Stock
Long-term capital gains were totally free from taxes until the year 2018. Any equity or stock held for more than a year may be sold for a profit without being subject to taxes. This action was taken to promote market cash liquidity and increase domestic wealth. A different approach was taken to this tactic in the 2018 budget, which chose to tax long-term capital gains as well. Any capital gains from assets held for more than a year would now be subject to a 10% tax.
However because long-term investments still adhere to the goodwill principle, long-term investors were given several exclusions to avoid paying long-term capital gains tax.
So let’s take a look at these conditions that make a long-term capital gain exempt from taxation.
Exemptions for Long-Term Capital Gains
First off, section 112A exempts from taxation capital gains that are less than one lakh rupees. So, ensuring that your capital gains stay under the exemption rate is one of the greatest methods to avoid paying capital gains tax when you sell your shares. The greatest method to profit from your assets is to make timely, little investments. Second, if a long-term investor invests the profits from the sale of shares elsewhere, they are eligible for a tax exemption under section 54F. But, there are restrictions on how and where you may invest the money. For capital gains tax reduction, you can use the funds from the divestiture in the following way.
- You can invest in real estate within two years of making the sale in a maximum of two real estate properties as long as the properties remain unsold for a period of three years after purchase
- If you have made an investment in a real estate property within one year prior to the sale of the stock, you can claim deduction of the cost of the investment against the capital gains and get exempted from capital gains tax. Again, the investment in the property has to be held for a period of three years after purchasing it
- You can invest the proceeds in a construction project as long as the construction is completed within three years of making the long term capital gains.
The taxation of long-term capital gains was a significant policy choice that may have an impact on the outlook of a long-term investor who had saved money with the intention of avoiding taxes when investing. Thus, the budget also included provisions to protect the investments of people who had used their resources to take advantage of the previous administration's programme by enacting the so-called "Grandfathering Rule."
The Grandfathering Rule
There was a lot of fear about the stock market going into a tailspin when the decision to tax long-term capital gains was announced in the 2018 budget. In order to address the worries of those long-term investors who had put their money in the stock market prior to the change in the policy of taxing their long-term capital gains, Section 112A was enacted. Investors who purchased stock market investments before January 31, 2018, and sold such investments before April 1, 2018, were totally excluded from long-term capital gains taxation. This provided the investors adequate opportunity to leave the market and transfer their funds to a different refuge if they disagreed with the choice to tax long-term capital gains. However, those who decided to continue to keep their faith in the stock market and bear the cost of taxation on long-term capital gains were given a slight relief for their continued patronage. Any investor who held long-term investments prior to 31 January 2018 and continued to hold those investments post 1 April 2008 would be given exemption from taxation in the following manner.
Now the universal formula for calculating capital gains is,
Selling Price – Cost of Acquisition
Typically, the purchase price of the shares counts as the cost of acquisition. But in order to provide the "Grandfathering Investors" with the greatest possible benefit, it was intended to give them the ability to increase their cost of acquisition in order to seek a reduction in the calculation of the capital gains and, as a result, a reduction in the capital gains tax liability. Hence, the cost of acquisition for shares bought before January 31, 2018, would be determined as follows under the "Grandfathering Rule" purposes.
Determine the stock's highest stated value on the stock market as of January 31, 2018, and then compare it to the price you are selling it for, choosing whichever is higher. First, you first determine the highest quoted value of the stock in the stock market as on 31 January, 2018 and you compare it with the price at which you are selling the stock and select whichever value is lower amongst the two.
Next, you take the value selected in the previous step and compare it with the cost at which you bought the stock. Whichever is the highest amongst these two values is considered to be the ‘cost of acquisition’.
Illustration for the ‘Grandfathering Effect’ on the Calculation of Long Term Capital Gains Tax on Sale of Stock
Consider a stock that was purchased for 10,000 and sold for 15,000 after being held for two years. Thus we use the general formula of selling price minus buying price to get the long-term capital gains on this transaction. That example, 15,000 less 10,000 equals 5,000.
Hence, the 10% long-term capital gains tax on $5,000, or $500, is determined.
To further appreciate how the "Grandfather Rule" affects this scenario, let's now add additional restrictions. Let's assume that the stock was purchased before January 31, 2018. This raises doubts about the "cost of acquisition," which is determined differently in accordance with Section 112A's rules.
We first look at the highest quoted price of the stock on 31 January 2018. Let’s say the stock touched a high of ₹12,000 during the trading day of 31 January 2018. You compare that with the selling price, which is ₹15,000 and select the lower of the two, which is ₹12,000.
Next, you compare that value with the cost at which you bought the stock, which is ₹10,000 and select the higher of the two. So the cost of acquisition would be ₹12,000,enhancing the buying cost by ₹2,000. The computation of the long term capital Gain by applying the universal formula would now be,
₹15,000 – ₹12,000 = ₹3,000
Thus reducing the value of the long term capital gains by ₹2,000 and ultimately reducing the long term capital gains tax liability to ₹300, down from ₹500.
The idea of these rules is to incentivize people enough to ensure that they continue to invest in the stock market, which in turn fund projects that build national wealth and GDP overall. Get in touch with our experts at Beyond Books N Compliance today to understand the true value of your long term and short-term investments in stock and to learn how to structure them in a way to maximize the returns on your investment.