Section 54, IT Act, 1961 provides exemption from capital gains tax if an assessee sells residential house and reinvests the capital gains in another residential house. While core of the Section 54 has remained unaltered, various amendments to the provision have altered the scope of exemption. For example, the benefit of Section 54 was earlier was only available only to an individual, but the provision was amended via Finance Act, 1987 to extend the benefit of tax exemption to both – an individual and a Hindu Undivided Family (‘HUF’). While Section 54 has been similarly amended multiple times, this article is an attempt to catalogue three important amendments to the provisions that have materially altered its scope and examines the rationale for each of the amendments.
A Residential House -> One Residential House in India
Section 54 – before 2014 – provided that when an individual or HUF has within one year before or two years after transfer of the original asset purchased or constructed ‘a residential house’, then the assessee shall be eligible for capital gains tax exemption as per the conditions specified in the provision. There were two interpretive questions that arose from the phrase ‘a residential house’. First, whether different residential units constitute a residential house; Second, whether it was essential to purchase OR construct a residential house in India or whether it could be anywhere outside India too.
As regards the first, courts took the view that if an assessee purchases different residential flats, they all qualify for exemption under Section 54. In one case, the Karnataka High Court reasoned as follows:
The context in which the expression ‘a residential house’ is used in Section 54 makes it clear that, it was not the intention of the legislation to convey the meaning that: it refers to a single residential house, if, that was the intention, they would have used the word “one.”
In the impugned case, the assessee had purchased four residential flats in a single residential building. The High Court held that the four flats constituted ‘a residential house’ and not ‘four residential houseS’ and tax exemption for the assessee needs to be determined accordingly.
Similarly, the Delhi High Court in another case, endorsed the Karnataka High Court’s stance and observed that as long as the assessee acquires a building which may be constructed to consist of several units which if need arises can be independently and separately used as residences, the requirement of Section 54 is fulfilled. There is no requirement that the residential house should be constructed in a particular manner or that it cannot have independent units.
As regards the second issue, ITAT in one of its decision was categorical in its conclusion that purchase of residential house outside India does not preclude an assessee from claiming the benefit of Section 54. The ITAT noted that:
It does not exclude the right of the assessee to claim the property purchased in a foreign country, if all other conditions laid down in the section are satisfied, merely because the property acquired is in a foreign country.
It was partially in response to the above judicial interpretations, that Section 54 was amended via Finance Act, 2014 and the phrase ‘a residential house’ was replaced with ‘one residential house in India’. In the accompanying document to the Finance Act, 2014 it was clarified, that the benefit under Section 54 was aimed for investment of capital gains made in one residential house in India, and the provision has been amended to reflect the said legislative intent. This was the first major amendment to Section 54 that altered its scope and clarified its intent. Though the courts were not incorrect in interpreting the pre-2014 provision in the manner that they did, particularly the lack of clarity that reinvestment should be made in a residential house in India.
Purchase of Two Houses
While the Finance Act, 2014 restricted the benefit of tax exemption under Section 54 to only one residential house, the Finance Act, 2019 did the opposite and expanded the scope of exemption. Section 54 was amended in 2019 to enable an assessee to claim exemption even if the capital gains from the first residential house were invested in two houses. Two Provisos were added to Section 54 via Finance Act, 2019 which allowed an assessee to claim benefit of Section 54 if: first, the assessee had not made capital gains of more than 2 crores on selling the first residential house; second, it was provided that if the assessee exercised the option of claiming the tax benefit on two houses, he shall not be subsequently entitled to exercise the option for the same or any other assessement year.
The legislature, thus, in 2019, expanded the scope of Section 54 but with two important caveats of an upper limit of capital gains and it being once in a lifetime option. Generally, there is no limit on the no. of times an assessee can claim the benefit of Section 54, but if the exemption is claimed in respect of two residential houses, then further benefit of Section 54 is not permissible. There is no clarity as to why both the restriction(s) have been imposed vis-à-vis exemption on the two residential houses. Otherwise, the legislature certainly thought fit to expand the scope of exemption in 2019 after limiting the scope to one house in 2014.
Cap of Ten Crores
The third important amendment to Section 54 was made via Finance Act, 2023. The amendment to Section 54 – and simultaneously Section 54F – was to the effect that the maximum benefit that can be claimed by an assessee under the provision was Rs 10 crores. Thus, if an assessee purchased a new asset worth more than Rs 10 crores, then it would presumed that the cost of new asset was Rs 10 crores. Why impose an upper limit of Rs 10 crores? The accompanying explanation for the amendment clarified that:
The primary objective of the sections 54 and section 54F of the Act was to mitigate the acute shortage of housing, and to give impetus to house building activity. However, it has been observed that claims of huge deductions by high-net-worth assessees are being made under these provisions, by purchasing very expensive residential houses. It is defeating the very purpose of these sections.
The above rationale while partially understandable does not fully explain how the upper limit of Rs 10 crores was arrived at. Neither are the unintended consequences of prescribing the upper limit are, for now, fully decipherable. We do not know if in the bid to restrict tax exemption claims of high net worth individuals, we are also preventing tax exemptions claim of taxpayers who may wish to liquidate their high value residence in favor of their offsprings or otherwise distribute wealth to the next generation. In such cases, the intent may not be to purchase more expensive residential houses, but the taxpayer may suffer due to imposition of the upper limit.
Conclusion
Section 54 is a beneficial provision for assessees and helps mitigate the tax liabilities of a significant no. of taxpayers who sell one residential house to purchase another. The provision has undergone some changes to clarify legislative intent and prevent a certain category of taxpayers from taking undue advantange of the tax exemption. At the same time, some of the conditions and restrictions to avail the exemption are not fully explained. While a tax exemption is always provided subject to certain conditions and restrictions, if they are fully explained and rational, it is easier to understand their scope. Finally, while currently the Section 54 seems to have a relatively settled interpretive scope, one cannot with authority and full confidence state if further uncertainty may not arise and may catalyze further amendments to the provision.