Should you buy capital gain bonds & save property gains tax?

Congratulations on selling your property recently, but the bad news is that you need to pay tax on the gains.

However, there's one way you can escape paying tax, and that's by investing the gains in capital gain bonds within six months of selling the property.

These bonds offer a way to defer taxes, but do they truly make financial sense?

Instead, will it be better to pay the tax and invest the remaining amount in equity funds?

Before we dive into the comparison, let's take a closer look at capital-gains bonds and what they bring to the table.

What are capital gain bonds?

These fixed-income bonds offer tax exemption on capital gains but come with a five-year lock-in and a maximum investment limit of Rs 50 lakh.

They currently offer an interest rate of 5.25 per cent, paid annually, but the interest is taxable as per slab rates.

Additionally, these bonds cannot be sold, transferred or used as collateral during the lock-in period.

Example
Say you bought a piece of land and sold it after a few years at a profit of Rs 50 lakh. If you opt to pay tax, you'd have to hand over Rs 6.25 lakh to the taxman. (There are two ways capital gains can be taxed after selling a property. Read here to know about them.)

But if you invest the Rs 50 lakh gain in capital gain bonds, your tax bill is zero. Not only that, you start earning 5.25 per cent interest every year (though this interest is taxable).

Net-net, you earn a pre-tax interest of Rs 2.62 lakh per year.

However, since the interest is taxable as per your income slab, if you fall in the 30 per cent tax bracket, your post-tax interest comes down to Rs 1.84 lakh per year. Over five years, this totals Rs 9.19 lakh in earnings.

Add this to your initial investment and your total investment value after five years will be Rs 59.19 lakh.

But is there an even better option than this?

Pay the taxes and choose equity

Let's take you through two scenarios. The first case is for more aggressive investors, and the second is for a more risk-off investor.

Case 1: Paid capital gains and invested the remaining amount in a flexi-cap fund

Instead of investing in capital gains bonds, you pay Rs 6.25 lakh in taxes on your Rs 50 lakh gains and invest the remaining Rs 43.75 lakh in a flexi-cap fund.

Based on the average five-year rolling return of 12.51 per cent, your investment grows to Rs 78.87 lakh after five years.

However, since equity gains are taxable at 12.5 per cent, you would pay Rs 4.39 lakh in taxes on the gains. This leaves you with a post-tax value of Rs 74.48 lakh, significantly higher than what you would have earned from capital-gains bonds (Rs 59.19 lakh).

Case 2: Paid capital gains and invested the remaining amount in an aggressive hybrid fund

In this case, you pay Rs 6.25 lakh in taxes on your Rs 50 lakh capital gains and invest the remaining Rs 43.75 lakh in an aggressive hybrid fund.

With an average five-year rolling return of 11.75 per cent, your investment grows to Rs 76.25 lakh over five years.

After accounting for capital gains tax of 12.5 per cent, the post-tax investment value comes to Rs 72.19 lakh, significantly higher than what you would have earned from capital gains bonds.

Key observations

• Historical data makes a strong case for equity funds over capital-gains bonds. Over the last 15 years, post-tax five-year rolling returns show that flexi-cap and aggressive hybrid funds have outperformed capital gain bonds (which currently offer 5.25 per cent returns) in 87.9 per cent and 94.5 per cent of cases, respectively.
• On a post-tax basis, these funds have delivered more than double the returns of capital gain bonds (above 10.5 per cent) in 56.6 per cent of cases for flexi-cap funds and 50.2 per cent for aggressive hybrid funds.
• Many investors hesitate to invest in equities due to their volatility, fearing potential losses. However, the data tells a different story. Based on post-tax five-year rolling returns, the chances of getting negative returns are extremely low: just 0.29 per cent for flexi-cap funds and 0.08 per cent for aggressive hybrid funds.

Please note that we assumed lump-sum investments in flexi-cap and aggressive hybrid funds for a fair comparison with capital-gain bonds. However, in any other case, it's best to spread your investment over several months to avoid the risk of entering the market at an unfavourable level.

The last word

Sure, capital gain bonds help you save on taxes, but what's the point if, after five years, you end up with less wealth than if you had simply paid the tax and invested wisely? These bonds may offer short-term relief by avoiding an immediate tax hit, but in the long run, they limit your growth potential.

Instead, the smarter move would be to put your money in a diversified equity fund. In their case, the potential for higher returns far outweighs the temporary tax savings.

Also read: Should you invest in gold or debt for stability?

This article was originally published on February 24, 2025.