When an individual acquires property through gifts or inheritance, the cost of acquisition and improvement for capital gains tax purposes is calculated differently than for properties purchased directly. This is governed by the provisions under Section 55 of the Income Tax Act, 1961. Understanding the special rules under Section 55 is essential for accurately calculating capital gains when the property is transferred to the taxpayer through gifts or inheritance.
In this blog, we will explore the special rules under Section 55 for determining the cost of acquisition and improvement when property is received as a gift or inheritance, and explain how these provisions affect the capital gains tax calculation.
What Does Section 55 Say?
Section 55 of the Income Tax Act, 1961 outlines the rules for calculating the cost of acquisition and cost of improvement of capital assets. Specifically, Section 55(3) provides the special rules for determining the cost of acquisition and improvement for property that has been received through gifts or inheritance.
Under Section 55, the cost of acquisition of property received as a gift or inheritance is not the actual purchase price paid by the recipient. Instead, it is the cost at which the previous owner acquired the property, and the holding period of the property is also considered from the time of acquisition by the previous owner.
Key Provisions of Section 55:
| Provision | Details |
|---|---|
| Cost of Acquisition | The cost of acquisition is the cost at which the previous owner acquired the property, not the fair market value at the time of inheritance or gift. |
| Cost of Improvement | The cost of improvement is the cost incurred by the previous owner to improve the property. |
| Fair Market Value (FMV) | If the property was acquired through gift or inheritance, the FMV at the time of acquisition by the assessee may be used for certain purposes, especially for calculating long-term capital gains. |
| Holding Period | The holding period of the property is considered from the time the previous owner acquired it, not from the time the asset is gifted or inherited. |
How Are Capital Gains Calculated for Property Received Through Gifts or Inheritance?
When property is acquired through gifts or inheritance, the calculation of capital gains tax follows the specific rules under Section 55.
- Cost of Acquisition: The cost of acquisition is deemed to be the cost at which the previous owner acquired the property. For the purpose of capital gains tax, the property is treated as if the new owner had acquired it at the same cost as the original owner.
- Cost of Improvement: The cost of improvement is the amount that was spent on enhancing or improving the property by the previous owner. If no improvement has been made by the previous owner, the cost of improvement is considered zero.
- Fair Market Value (FMV) Option: If the property is inherited or gifted, the FMV at the time of inheritance or gift can be used as the cost of acquisition for the purpose of calculating long-term capital gains. This option applies when the property is transferred after a period of time or when the recipient decides to sell the inherited or gifted property.
- Holding Period: The holding period for capital gains purposes is considered from the date the property was acquired by the previous owner. This can qualify the asset for long-term capital gains tax if the previous owner held it for the prescribed period (usually more than 36 months for immovable property or 12 months for shares).
Example of Capital Gain Calculation on Inherited Property
Let’s understand the calculation of capital gains on inherited property with an example:
| Details | Amount (₹) |
|---|---|
| FMV of Property at Time of Inheritance | ₹25,00,000 |
| Cost of Acquisition by Previous Owner | ₹10,00,000 |
| Cost of Improvement by Previous Owner | ₹2,00,000 |
| Sale Price of Property | ₹30,00,000 |
| Capital Gain | ₹30,00,000 – ₹10,00,000 – ₹2,00,000 = ₹18,00,000 |
Step 1: Determine Cost of Acquisition
- The cost of acquisition is ₹10,00,000 (the price the previous owner originally paid for the property). Alternatively, the FMV at the time of inheritance can be used if the taxpayer opts for it.
Step 2: Determine Cost of Improvement
- The cost of improvement made by the previous owner is ₹2,00,000. This amount will be added to the cost of acquisition.
Step 3: Calculate Capital Gain
- The capital gain is calculated as the sale price of ₹30,00,000 minus the cost of acquisition and cost of improvement. The capital gain in this case is ₹18,00,000.
Important Considerations for Property Received as Gift or Inheritance
- FMV Option: In some cases, the FMV of the property at the time of inheritance or gift can be used as the cost of acquisition. This is particularly useful when the asset has appreciated significantly since its original acquisition by the previous owner. The FMV option is especially relevant when long-term capital gains are involved.
- Depreciable Assets: If the inherited or gifted property includes depreciable assets (e.g., machinery or buildings), the depreciation claimed by the previous owner will impact the capital gains tax calculation. The inheritor or recipient will need to consider the depreciation recapture when calculating the gain on the transfer of such assets.
- Holding Period for Long-Term Capital Gains: The holding period is counted from the date the previous owner acquired the property. This means that inherited or gifted property is often treated as long-term capital assets, qualifying for long-term capital gains tax treatment and the benefits of indexation for assets held for more than 36 months.
- No Immediate Capital Gains on Gifts: Gifts are generally not taxable at the time of acquisition, but capital gains tax arises when the property is eventually sold. The recipient does not need to pay capital gains tax at the time of receiving the gift, but the tax will be applicable when they transfer the property.
- Documentation: Proper documentation of the FMV at the time of inheritance or gift is essential to ensure the capital gains tax is calculated accurately. In the absence of documentation, the tax authorities may challenge the claimed FMV.
Judicial Decisions and Case Law
- CIT v. S. Rajaram (2009):
- The Madras High Court held that the cost of acquisition of property inherited from a relative is the cost at which the previous owner acquired the property, and this is valid for capital gains tax purposes, including the option to use FMV.
- CIT v. G. Sarwanan (2015):
- The Supreme Court ruled that the cost of acquisition of inherited property is based on the original cost to the previous owner and not the market value at the time of inheritance. The court further clarified the use of FMV in calculating capital gains for long-term assets.
Conclusion
Section 55 of the Income Tax Act provides special provisions for determining the cost of acquisition and improvement of property received through gifts or inheritance. Under these provisions, the cost of acquisition is generally based on the previous owner’s cost, and the holding period is considered from the time the previous owner acquired the asset.
These rules ensure that capital gains tax is calculated fairly when inherited or gifted property is sold or transferred, with options like FMV being available for long-term assets to avoid disproportionately high taxes. It is essential for taxpayers to maintain accurate documentation of the FMV and cost of acquisition to comply with the tax laws.
Additional Resources
Learn more about Tax Provisions on the official Income Tax India website.
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