In this article, we will see does it really make sense to invest money in capital gains bonds issued by REC (Rural Electrification Corporation) or National Housing Board (NHB) etc.You have 6 months to buy these bonds from the capital gains. These bonds give 8% to 9% returns on average and you have to remain invested for 3 years to avail the savings on tax. However, the returns on these bonds are taxable. It means your effective return is about 6% to 7%. We have the following situation. A person bought an apartment in 2008 at about 46 lakhs and sold in 2012 at 1 crore. First let;s find out the tax obligation and then we will see how we can use this money for better returns over next few years.

 


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Year Value
Cost Inflation Index 2008-2009 582
Cost Inflation Index 2012-2013 852
   
Cost of house (in 2008-2009)     4,599,551
Inflation adjusted cost of house     6,733,363
   
Sale price  10,000,000
   
Profit     3,266,637
Tax (at 20%)        653,327

 A scenario analysis

The question is does it really make sense to invest in an asset that gives 6% to 7% returns for 3 years to save taxes of 20% on capital gain now. For this, we have to understand what alternatives are available to us.  We have taken 3 scenarios here. In each of the scenario, we are comparing the returns (including the savings on tax) with pure equity mutual funds and balanced fund. Let's take a look.

CASE - 1 (Investment Horizon = 3 years)

Capital gains

Tax

Invested amount

Investment Options

Tenure

Post tax return

Final value

      3,266,637

0.00%

          3,266,636.68

Tax savings bonds

3

6.50%

   3,945,933

      3,266,637

20.00%

          2,613,309.34

Equity mutual fund

3

14.00%

   3,871,733

      3,266,637

20.00%

          2,613,309.34

Balance Fund

3

11.00%

   3,574,043

CASE - 2 (Investment Horizon = 5 years)

Capital gains

Tax

Invested amount

Investment Options

Tenure

Returns

Final value

      3,266,637

0.00%

          3,266,636.68

Tax savings bonds

5

6.50%

   4,475,575

      3,266,637

20.00%

          2,613,309.34

Equity mutual fund

5

14.00%

   5,031,704

      3,266,637

20.00%

          2,613,309.34

Balance Fund

5

11.00%

   4,403,578

CASE - 3 (Investment Horizon = 8 years)

Capital gains

Tax

Invested amount

Investment Options

Tenure

Returns

Final value

      3,266,637

0.00%

          3,266,636.68

Tax savings bonds

8

6.50%

   5,406,270

      3,266,637

20.00%

          2,613,309.34

Equity mutual fund

8

14.00%

   7,454,691

      3,266,637

20.00%

          2,613,309.34

Balance Fund

8

11.00%

   6,022,470

Typically, equity funds are know to have given the best returns. It can vary between 10% to 18% depending upon the time horizon and market condition. A longer investment horizon will average market fluctuation resulting in better return than any other finnacial asset. Similarly, a balanced fund invests part of the fund in equity and part in debt. Hence balanced funds are less risky than equity funds but the returns also are lower than that of the equity funds. Balanced funds have given a return of 7% to 14% in the past. Hence we have taken 11% as average return.

We can see that in case 2 and case 3, equity mutual fund and balanced fund beat the savings and returns combined achieved on capital gain bonds. Only place where the return is marginally higher is when the investor is invested for just 3 years, barely enough to claim the tax benefit on capital gain.

 

Points to consider

Risk - Higher reward requires higher risk. In case of equity mutual funds, risks are the highest in all funds category. Risk in balanced fund is much lower compared to equity funds and hence they also give you lower return. Moreover, the returns will not be uniform every year. It will fluctuate. Unless you are ready for this, investing in murual funds will not be a good idea.

Investment horizon - If you can expand your investment horizon to 5 years to 10 years, the last two cases will give you much better returns compared to capital gain bonds. Investors should look at these options seriously and decide their investment horizon to make sure they get the best deal out of their investment.

Objective - What is your objective? If tax saving is the only objective, go for the first option. However, in my view tax saving should not be the objective. Rather, investor should look at wealth building. If your goal is latter one, go for last two cases.

 

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