One of the ways of saving tax on long-term capital gains is by investing in the bonds issued by NHAI or REC. This deduction is under Sec. 54EC of the Income Tax Act. The maximum limit for such investment in any FY is Rs. 50 lakh. Since the main function of these bonds is the tax deduction, the interest rate on offer is a modest 6% p.a.
It is on account of this low interest rate that many investors opt to pay the entire amount of tax and invest the balance in shares or quality equity funds. Their reasoning is on the following lines — while it is true that investing in the bonds could save them tax, the bonds per se offer very little — that too fully taxable. Plus the money is locked in for three years. Wouldn’t it be a better idea instead, to pay the tax and earn good returns with the remaining money?
To find out, we decided to run some numbers. The analysis threw up some fascinating results and this week we shall share the same with readers.
The Analysis
Here’s what we found. If you are lucky enough to have earned long-term capital gains, the Sec. 54EC bonds is one of the best investments you could make. In spite of the fact that the returns are low. In spite of the fact that the interest is taxable. And in spite of the fact that there is a three year lock-in. Why? Examine the following table.
We assume that the asset has been sold on 31st July 2011. The rest is self-explanatory.
The key thing is that on account of the tax saving, the bonds effectively offer the investor an up-front 20% discount. It is like investing Rs. 80 but earning a return on Rs. 100. Also the 20% gets spread over just three years which is the lock-in period of the bonds.
For example, in the above table, say the investor has earned a capital gain of Rs. 100. Effectively he will end up investing Rs. 80 in the bonds as he saves a tax of Rs.20. At the rate of 6%, he earns Rs. 6 every year and at the end of three years, he gets his original investment back.
The net equivalent return works out to an eye popping 12.60% p.a. after tax! And if the investor does not have other taxable income, the return climbs to 14.70% p.a!
Any which way you look at it, investing in these bonds is like getting to save his tax and also get paid for it!! One should be crazy not to go for it.
As already mentioned earlier, the earlier idea was to pay tax and take the remaining funds to greener pastures. Therefore we thought it could also be interesting to see how green the pasture should exactly be.
Lets say one were to invest Rs. 1 lakh in the market. At the rate of 14.70% p.a. over three years the money should grow to around Rs. 1,51,000 i.e. almost 50% more. And this is just to break even. After that the investor will actually start making any money.
Rs. 50 lakh limit
Last but not the least, it may be noted that these Sec. 54EC bonds may be used to save tax on any long-term capital gain and not necessarily that from sale of property. For example, apart from property, sale of say non-equity mutual funds, bonds, debentures gold, jewellery or even gold ETFs etc. may result in long-term capital gains. Such gains may be saved by investing the capital gain amount in the 54EC bonds as detailed above.
There is only one drawback to these bonds — the maximum investment in any one financial year is capped at Rs. 50 lakh. While by no means a small amount, however, the way property prices have spiraled, some investors found it was not enough to cover the entire amount of capital gains.
However, some smart planning used to come to the rescue. Remember, one has six months to invest in the bonds from the time of earning the capital gain. If one found that one would need a tax cover of more than Rs. 50 lakh, then the sale transaction was timed between December and March of any year. This way, the six month period overlapped two financial years which would in turn enable the investor to double the investible amount to Rs. 1 crore.
However, Budget 2014 has plugged this loophole and now a maximum of Rs. 50 lakh only may be invested for any transaction.
(The authors may be contacted at wonderlandconsultants@yahoo.com)
