Long-term capital gains (LTCG) tax from sale of property can be saved, on gains of up to Rs 50 lakh, by investing in capital gains tax exemption bonds issued by certain Public Sector Undertakings (PSUs). These bonds have a lock-in; earlier the lock-in period was three years, since April 2018 it is five years. The rate of interest available on these bonds is 5.75%, which is taxable.
Comparison of options
One option to save the LTCG tax is by investing in these bonds and locking in your money for five years. The other option is to pay the tax, keep your money liquid, and invest in avenues yielding higher than 5.75%. To get a perspective, let us compare returns. The assumptions are as follows: there is LTCG of Rs 50 lakh, post indexation. This quantum, if invested in 54EC bonds, would fetch a coupon rate of 5.75%. This is taxable at 30%, ignoring surcharge and cess for simplicity.
Hence the net return is around 4% from the bond. As against this, if we decide to pay the tax, it is taxable at 20%, ignoring surcharge and cess for simplicity. After paying a tax of Rs 10 lakh, what remains for investment is `40 lakh. We will look at three options for investing Rs 40 lakh.
Investing in tax-free PSU bonds
We assume a yield of 5.7% for investing in tax-free PSU bonds. So, Rs 50 lakh invested in 54EC bonds, compounding at around 4% per year, grows to more than Rs 60 lakh after five years.
In fact, Rs 40 lakh, invested at 5.7% tax-free, grows to less than Rs 53 lakh after five years. That is, investing in 54EC at 5.75% taxable bonds is a better option over paying the LTCG tax and investing remaining amount in 5.7% tax-free.
Investing in Bank AT1 Perpetual bonds
The range of yields in Bank AT1 Perpetual bonds is wide, we assume 9% to strike a balance between risk (higher yield but higher risk) and reward (lower yield but lower risk). So, 9% return taxed at 30% means a net return of 6.3%. As we saw, Rs 50 lakh invested in 54EC bonds, yielding 4% net, compounds to more than Rs 60 lakh after five years. As against this, Rs 40 lakh invested at approximately 6.3% net, grows to less than Rs 55 lakh after five years. Though a little better than Rs 53 lakh in the previous comparison, it is still lower than Rs 60 lakh. That is, 54EC bonds yielding 5.75% taxable is a better option.
Investing in equity
It is not a correct comparison between investment in bonds and equities, as these have different risk-return profiles. Just for the sake of a perspective, to get the break-even rate and complete this discussion, if Rs 40 lakh is invested in equities which gives an assumed return of 10% per year taxable at 10% (equity LTCG tax rate), i.e., it compounds at 9% per year, it grows to more than Rs 61 lakh after five years.
That is, the break-even rate for Rs 40 lakh to outperform Rs 50 lakh over five years at 4% net of tax, is 9% net of tax.
Conclusion
The break-even rate to beat the 54EC bond, in case of LTCG from property, etc., is steep. It is usually not available from another bond; it will be available only from another bond with a much higher credit risk vis-à-vis a AAA rated PSU issuer.
Hence either equity or a riskier bond not being a fair comparison to a safe bond, it is advisable to save the tax and settle for 5.75%. However, it is a good practice to do a comparison of the options available.