A recent ruling by the Income Tax Appellate Tribunal (ITAT) in Mumbai has clarified the eligibility for capital gains exemption under Section 54 of the Income Tax Act, 1961, when a property is gifted between spouses. The ITAT held that a wife who receives a property as a gift from her husband can claim an exemption under Section 54 if she sells the property and reinvests the proceeds in a new residential property. However, this exemption is subject to certain conditions, including the applicability of clubbing provisions and capital gains rules.

Key Points of the Ruling

• Eligibility for Exemption: The ITAT Mumbai ruled that a wife is eligible to claim capital gains exemption under Section 54 of the Income Tax Act, even if the property was initially gifted to her by her husband. This means that if she sells the gifted property and invests the sale proceeds in a new residential property within the stipulated time frame, she can claim exemption from capital gains tax.
• Conditions for Exemption: The exemption is granted provided all the statutory conditions under Section 54 are met. This includes reinvestment in a new property within one year before or two years after the sale of the original property, or construction of a new house within three years from the date of sale.
• Clubbing Provisions: Even with a valid legal transfer, financial trails and compliance play a crucial role in determining tax exemption eligibility. Clubbing provisions may apply where income indirectly arises back to the spouse who gifted the asset. Clubbing of income means adding someone else's income to your own and paying tax on it.
• No Tax on Gift: Under the Income Tax Act, gifts received from relatives, including a spouse, are not treated as income and are exempt from capital gains tax at the time of transfer. However, implications become complex if the property is sold later.
• Scrutiny and Compliance: Even when the transaction is legally valid, scrutiny of financial trails and compliance plays a pivotal role in determining eligibility for tax exemption. The tax department may look into potential tax avoidance, circular transactions, and the proper use of sale proceeds.
• Joint Ownership: The ITAT has also clarified that the Section 54 capital gains tax exemption cannot be denied merely because the new property was purchased jointly in the names of the wife and her husband. The exemption can be claimed to the extent of the individual's investment, provided there is no double claim.
• Inherited Property: You can claim exemption under Section 54 even if the residential property sold was inherited or gifted. The only condition is that it should be classified as a long-term capital asset, meaning the property must have been held for more than 24 months before the sale.

Section 54 of the Income Tax Act

Section 54 of the Income Tax Act provides an exemption from long-term capital gains tax if an individual or a Hindu Undivided Family (HUF) sells a residential house property and reinvests the capital gains in purchasing or constructing another residential house within a specified period. The new residential property must be located in India to qualify for the exemption. The exemption is capped at Rs. 10 crore from April 1, 2023.

Implications

This ruling offers clarity on the tax implications of property transfers between spouses and the availability of capital gains exemptions. It reinforces that genuine transactions with valid documentation can avail of tax benefits, but also highlights the importance of complying with all statutory requirements and maintaining proper financial records to avoid scrutiny from tax authorities. The decision underscores the importance of a liberal interpretation of tax laws like Section 54 to promote residential property ownership.