Should you invest in capital gain bonds after selling your property?

Is it better to invest in the Section 54EC bonds issued by Rural Electrification Corporation (REC), Power Finance Corporation (PFC) and the Indian Railways Finance Corporation (IRFC) for saving long-term capital gains tax on sale of property than paying the tax upfront and deploy the remaining amount in other equity-based investments? - Anil Misra

When you sell a property, the gains are taxed at 20 per cent after indexation if you hold it for more than two years.

However, Section 54EC of the Income Tax Act allows a deduction of up to Rs 50 lakh from the profit if invested in capital gain bonds within six months from the day you sell your property.

This means putting your money in such bonds can save you up to Rs 10 lakh on taxes (20 per cent of Rs 50 lakh).

What are capital gain bonds?

These bonds are fixed-income instruments issued by government-backed infrastructure financing companies, such as Rural Electrification Corporation (REC), Power Finance Corporation (PFC) and the Indian Railways Finance Corporation (IRFC).

Capital gain bonds have a lock-in period of five years and currently offer an annual interest of 5.25 per cent. The interest income is added to the taxable income every year and taxed as per the applicable slab.

So, for anyone who falls in the 30 per cent tax bracket, the post-tax return turns out to be a measly 3.68 per cent.

Should you invest in them?

Compared with equity funds, an annual return of 5.25 per cent (pre-tax) seems too low. In fact, the SIP return of an average flexi-cap fund over the last five years is over 20 per cent.

This means that if you had taken a tax hit of Rs 10 lakh upfront (20 per cent of Rs 50 lakh) and invested the remaining Rs 40 lakh in a flexi-cap fund in equal instalments over the next five years, your investment would have grown close to Rs 70 lakh. (Please note that a three-year period is usually sufficient to spread your investment).

In contrast, the Rs 50 lakh invested in capital gain bonds would have grown to just a little over Rs 63 lakh.

Therefore, going purely by logic and numbers, it makes sense to take the tax hit upfront and invest in an equity mutual fund.

That said, paying an upfront tax of Rs 10 lakh in the hope of higher returns from equities can get complicated. Though one can expect reasonably higher returns from equities over five to seven years, they are not guaranteed and, more importantly, prone to sharp ups and downs.

On the other hand, capital gain bonds offer assured returns.

Also, comparing the two options, investing in capital gain bonds saves you Rs 10 lakh in taxes, which you'd have to pay if you invest in equity funds. Considering this saving, the annual return of a capital gain bond is actually over 10 per cent, and not 5.25 per cent, which is relatively healthy for a five-year fixed-income option.

Our take

If you are looking at the safer, risk-free option and need the money after five years, invest in capital gain bonds.

But if you want to go by logic and numbers, are open to taking a bit of risk and would not mind extending the five-year tenure, take the tax hit and invest in equity funds.

Also read: Three ways to save tax after selling a house