ITR filing: Claimed capital gains exemption? The 3-year tax trap that may trigger income-tax notices
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ITR filing: Claimed capital gains exemption? The 3-year tax trap that may trigger income-tax notices
Every year, many taxpayers who claimed exemption under Sections 54 and 54F of the Income-Tax Act, 1961 in earlier assessment years, receive income tax notices because they overlook the three-year rule governing the Capital Gains Account Scheme (CGAS).
A common misconception is that the capital gains tax liability remains deferred until the amount deposited in the Capital Gains Account Scheme (CGAS) is ultimately withdrawn. The Income-Tax Act, 1961, does not support this view.
Both Sections 54 and 54F of the Income-Tax Act, 1961, provide that where the amount deposited in the CGAS is not utilised within the prescribed period for the purchase or construction of a new residential house, the exemption does not continue indefinitely.
In both cases, the taxability arises on the expiry of three years from the date of transfer of the original long-term capital asset-being a residential house in the case of Section 54 and any other long-term capital asset (other than a residential house) in the case of Section 54F.
Accordingly, the capital gain related to the unutilised amount becomes taxable on the expiry of the prescribed three-year period, irrespective of whether the amount is withdrawn from the account at that time or continues to remain deposited. Unfortunately, this provision often escapes the attention of taxpayers while filing their income tax returns.
With the due date for filing ITRs for AY 2026-27 approaching, taxpayers who claimed exemption under Sections 54 or 54F in earlier years should carefully review their Capital Gains Account Scheme deposits to determine whether the prescribed three-year period has expired and whether any resultant capital gains have become taxable and need to be reported in their ITR.
Also read: Salaried employees beware! These 5 mistakes during ITR filing can trigger unexpected tax demands
Why taxpayers use the Capital Gains Account Scheme
Section 54 allows taxpayers to claim exemption from long-term capital gains arising from the transfer of a residential house, while Section 54F provides exemption in respect of long-term capital gains arising from the transfer of any long-term capital asset other than a residential house, provided the prescribed amount is invested in a residential house within the specified time and the other conditions prescribed under the respective provisions are satisfied.
However, taxpayers may not always be able to purchase or construct the new residential house before the due date for filing the income tax return under Section 139(1). To ensure that the exemption is not denied merely because the investment has not been completed by that date, the Income-tax Act, 1961, permits the unutilised amount to be deposited in the Capital Gains Account Scheme (CGAS) before the due date for filing the return. The amount deposited can subsequently be utilised for the purchase or construction of a residential house within the period prescribed under Sections 54 and 54F.
The amount required to be deposited differs under the two provisions. Under Section 54, the unutilised capital gains are required to be deposited. Under Section 54F, the unutilised net sale consideration (full value of consideration minus expenses connected with the transfer) is required to be deposited because the exemption is linked to the investment of the net sale consideration and not merely the capital gains.
The amount deposited in the CGAS is treated as a deemed investment for claiming the exemption, subject to its utilisation within the prescribed period.
Key differences between Sections 54 and 54F
| Particulars | Section 54 | Section 54F |
| Original asset sold | Residential house | Any long-term capital asset other than a residential house |
| Maximum permissible exemption | Rs 10 crore | Rs 10 crore |
| Amount required to be deposited in CGAS | Unutilised capital gains as on the due date for filing ITR | Unutilised net sale consideration as on due date for filing ITR |
| New asset to be acquired | Residential house in India | Residential house in India |
Where taxpayers go wrong
The confusion often begins after the money is deposited in the Capital Gains Account Scheme (CGAS).
Many taxpayers assume: “The amount becomes taxable only when I ultimately withdraw it from the Capital Gains Account.” This assumption finds no support in the Income-tax Act, 1961.
Sections 54(2) and 54F(4) clearly provide that if the amount deposited in the CGAS is not utilised within the prescribed period for purchasing or constructing a residential house, the tax exemption does not continue indefinitely.
Under Section 54, the unutilised capital gains become taxable as long-term capital gains in the previous year in which three years from the date of transfer of the original residential house expire.
Under Section 54F, the exemption is recomputed based on the net sale consideration actually invested within the prescribed period. Consequently, the proportionate capital gains attributable to the unutilised net sale consideration become taxable in the previous year in which three years from the date of transfer of the original capital asset expire.
In both cases, the taxability arises on the expiry of the prescribed three-year period and not on the ultimate withdrawal of money from the CGAS.
The three-year rule at a glance
| Situation | Section 54 | Section 54F |
| Amount deposited in CGAS is not fully utilised within the prescribed three-year period | Unutilised capital gains become taxable. | Exemption is recomputed and proportionate capital gains become taxable. |
| Year of taxability | Assessment year relevant to the financial year in which three years from the date of transfer expire | Assessment year relevant to the financial year in which three years from the date of transfer expire |
A practical illustration
Suppose Mr. A sold a residential house in July 2022 and earned a long-term capital gain of ?70 lakh. As he intended to purchase a new residential house but could not do so before the due date for filing his return for AY 2023-24, he claimed exemption under Section 54 by depositing the unutilised capital gain of ?70 lakh in the Capital Gains Account Scheme (CGAS) before the due date for filing the income tax return.
If Mr. A fails to utilise the amount for purchasing or constructing a new residential house by July 2025, the long-term capital gain of ?70 lakh represented by the unutilised amount lying in the CGAS becomes taxable in FY 2025-26 (AY 2026-27), being the financial year in which the prescribed three-year period expires.
This taxability arises even if the amount continues to remain in the CGAS and is withdrawn only in a subsequent financial year, say FY 2026-27. If Mr. A does not report the resultant capital gains while filing his return for AY 2026-27, he may subsequently receive an income tax notice for under-reporting of income.
Why taxpayers receive notices years after claiming the exemption
With technology-driven compliance and the increasing use of data analytics, the Income Tax Department is able to match capital gains transactions with exemptions claimed in earlier years and verify whether the resultant capital gains have been reported in the return of income for the relevant assessment year.
Where taxpayers fail to offer to tax the capital gains arising from the unutilised amount lying in the Capital Gains Account Scheme (CGAS) after the expiry of the prescribed three-year period, the omission may subsequently be detected by the Income-tax Department, resulting in income tax notices for under-reporting of income, along with consequential tax demands, interest, penalties and other legal consequences, wherever applicable.
In most cases, these disputes do not arise because taxpayers intended to evade tax. Rather, they stem from a misunderstanding of the provisions of Sections 54 and 54F, particularly the tax consequences of not utilising the amount deposited in the Capital Gains Account Scheme within the prescribed period.
A quick compliance checklist before filing ITR for AY 2026-27
Before filing your income-tax return for AY 2026-27, review the following:
- Did you deposit any amount in the Capital Gains Account Scheme (CGAS) to claim exemption under Section 54 or Section 54F in any earlier year?
- Was the amount deposited in the CGAS fully utilised within the prescribed period?
- If not, has the prescribed three-year period for the purchase or construction of the new residential house expired?
- If yes, have the resultant capital gains been offered to tax in the relevant assessment year?
If the capital gains represented by the unutilised amount have become taxable in AY 2026-27 and you have already filed your return without reporting them, you should evaluate the option of filing a revised income tax return, subject to the time limits prescribed under the Income-tax Act.
Similarly, where the omission relates to an earlier assessment year, taxpayers may evaluate the option of filing an updated return (ITR-U), wherever permissible and subject to the conditions and time limits prescribed under the Act.
A simple review of capital gains exemptions claimed in earlier years can help taxpayers avoid unnecessary tax liability, interest, penalties and prolonged litigation.
Don’t overlook this compliance check
The Capital Gains Account Scheme (CGAS) gives taxpayers additional time to reinvest their capital gains, but it does not defer taxation indefinitely. The law is clear: the trigger for taxability is the expiry of the prescribed three-year investment period, irrespective of when the money is ultimately withdrawn from the account.
With the Income Tax Department increasingly relying on data analytics to identify inconsistencies across assessment years, taxpayers should look beyond the current year’s transactions while filing their returns.
A review of earlier capital gains exemptions and CGAS deposits should be an integral part of the ITR filing process. Spending a few minutes on this compliance check today could help taxpayers avoid tax demands, interest, penalties and years of unnecessary litigation.
The author, O.P. Yadav, is a former IRS officer with over 36 years of experience in tax administration, education, and training. He is presently associated with Prosperr.io as Tax Evangelist. The views expressed are personal.
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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