Interesting facts about saving tax on long term capital gains

Author note

I was managing the finances of a client as he wanted to get his home reconstructed that is demolishing existing one and constructing new one, he had a good sum in mutual funds invested long ago with huge gains, how section 54F (Section 86 as per Income tax Act, 2025) is applicable on purchase or construction of new house, will it apply here? Let’s analyse it. Happy Reading

Section 54F Capital gain on transfer of certain capital assets not to be charged in case of investment in residential house.

In my client’s case all the conditions were satisfied, he wanted to sell his mutual funds and use those proceeds in demolishing and constructing his house, but he had a fear of getting notice as amount was huge.

Hence before advising him, I went through Income tax act and Judicial pronouncements

Introduction

Technically speaking, when an assessee demolishes an existing house on his own land and constructs a new residential house, in that case income tax department may question the availability of exemption as per Section 54 which is applicable when the original asset is a residential house or in my client’s case i.e. section 54F where original asset is any other long-term capital asset i.e. equity mutual finds.

Here the question arises that whether “construction” for the purposes of section 54 or 54F covers demolition followed by new construction on the same plot, or whether commencement of construction before the date of transfer disallow the assessee to claim exemption and how incidental costs like cost of demolition, reconstruction, as well as the land component shall be treated for computing the exempt amount.

This law have been interpreted by important high-court and tribunal rulings, but what the bare income tax act says?

Above I just discussed section 54F in one single line, but let’s expand a bit, Section 54 which was introduced for capital gain on transfer of a residential house, it gives assessee an exemption if capital gain is invested in purchase or construction of another residential house but the purchase should be made 1 year before or 2 years after transfer and the construction should be completed within 3 years.

Whereas, section 54F was introduced for the capital gain on transfer of any long-term capital asset other than a residential house, here the exemption is proportionate to investment of net consideration in purchase/construction of one residential house within the same timelines, the deposit should be made to the capital gains account scheme if not utilised before filing time limit.

Here law says that the investment should result in a residential house property owned by the assessee with other conditions such as not owning more than one other residential house on date of transfer, but law doesn’t expressly say that construction must start after the date of transfer, rather the focus of law is mainly on completion/purchase within prescribed periods.

Leading case laws

Commissioner of Income-tax Versus Bharti Mishra - 2014 (1) TMI 446 - DELHI HIGH COURT

Demolition of an old house and construction of a new house on the same plot qualifies as “construction” for the purpose of Section 54F, hence the commencement of construction prior to the date of sale does not automatically deny the assessee where conditions that are specified i.e. completion of construction within 3 years is done, and investment of net consideration is proved and there is compliance with CGAS rules i.e. amount is transferred to Capital gains account scheme before due date of ITR, In this case the delhi high court upheld the exemption and focussed on a beneficial interpretation of the provision.

Commissioner of Income-Tax Versus V. Pradeep Kumar And Another. - 2006 (4) TMI 99 - MADRAS High Court

In this case the high court of Madras delt with facts where the assessee claimed that the “construction” was only an extension/alteration of current premise but here the factual evidence did not showed it to be a genuine reconstruction for the purpose of creating a new residential house, held against the assessee. After analysing all the underlying facts, circumstances, and background information that was relevant to above case, the court gave a decision in favour of department. Hence, just mere extension of an existing structure will not qualify for an exemption as per section 54F even if all the conditions are fulfilled. In this case Pradeep Kumar remains authority for the proposition that substance matters if works are not truly construction of a new residential house, So, court said exemption can be denied.

CIT v. Ashok Narayan (Karnataka HC) (2009) 318 ITR 246

In this case, the karnataka high court in it’s decision that was cited in revenue/assessee authorities has also accepted that reconstruction on the same plot as qualifying construction, subject to facts that must show the genuine reconstruction to create a residential house and there should be proper compliance with timelines. By last two judgements I wanted to tell my readers that, the courts distinguished the cases of such full reconstruction from the cases of only repairs or extensions.

Pushpa Versus The Income Tax Officer, Ward No. 2 (2), Thiruvananthapuram - 2012 (8) TMI 1195 - KERALA HIGH COURT and various Tribunal rulings

Several decisions at tribunal and high-court levels have applied the same principles that is where the demolition and then fresh construction results in a new residential house, then the exemption of section 54F is available but in case only repairing or extension of residential property is done, or making improvements or changing the use of property is seen like converting the residential property in to shops, then in those cases the exemption may be refused.

Hence the courts continue to treat Sections 54/54F as beneficial to assessee and law shall not be interpreted strictly or technically, which could prevent the substantial justice from being served. Though the exact application depends on the nature of the project and whether those three conditions as I discussed above are properly complied with.

Practical implication

I read and understood many such case laws as I discussed above, now by understanding above cases I interpreted the whole scenario as the courts focuss on the substance over form that means was the work is actually a genuine reconstruction or a new construction that means really a complete demolition then fresh building is made or is it just a repair or extension, here also the substantial structural change may allow exemption. Here I advised my client to take photographs of current building, then when demonisation is done and next when new building is made, there are various cameras supporting location functions.

Next one is the time of commencement which means commencing construction before date of transfer is not an automatic bar, courts have allowed exemption provided completion not purchase falls within statutory period as governed by section and other conditions are met as I discussed above.

Scenario in case of one-house rule or change of use of the property, here, if the reconstructed property results in multiple units whether residential or commercial or part commercial (like constructing shops/offices), then in that case the income tax department may scrutinise the application of one house rule and genuineness of residential intent. Some decisions may allow reconstructed multiple residential units depending on facts of the case.

Last one is as I said earlier, there should be the proper documentation and evidence on assesses end, that means the architectural plans, the municipal permissions, the contractor agreements, the demarcated costs i.e. cost of demolition, construction, bank transfers or payments, invoices and completion certificate shall be stored by the assessee.

Things to remember while filing ITR

Assessee should state that the demolition and reconstruction is a genuine construction resulting in a new residential house and give dates of commencement of demolition as well as completion, along with that he must attach the architect’s certificate that the works constitute a new construction with structural changes rather than only extension or repair. Also, the utilisation of net consideration should be shown or in case construction is not completed before due date of filing ITR, in that case, the proof of CGAS deposit should be shown with the bank certificates.

In case the construction started prior to transfer, then the commercial/technical reasons need to be explained, it might be urgent safety demolition and emphasise completion within statutory period, here a case law of Commissioner of Income-tax Versus Bharti Mishra - 2014 (1) TMI 446 - DELHI HIGH COURT can be used.

The risk of litigation

First one is the “mere extension vs new construction” on factual grounds as I discussed in the case of Commissioner of Income-Tax Versus V. Pradeep Kumar And Another. - 2006 (4) TMI 99 - MADRAS High Court above.

Second one is in the case of change of use that means construction converted to shops or may be multiple commercial units, in that case the court may favour the department as no residential house is created or in the case of non-compliance with CGAS provisions or timelines hence the deposit proof and completion date is important.

Conclusion

I must conclude that the demolition and subsequent construction on the same plot may qualify for exemption as per the Section 54 or Section 54F, provided the reconstruction results in a fresh residential house, and the statutory timelines are met i.e. construction within 3 years, CGAS compliance is done for unutilised amounts, and documentary evidence proves genuineness. The Delhi High Court in the case of Bharti Mishra affirmed that commencement before sale can’t be denied where statutory conditions are satisfied, however, the Income tax department may send notice that could be based on the true nature of works which remains a risk.

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