Case 045Tax-aware portfolio movesCore

A client sells a property with a Rs 3 crore long-term gain. Compare buying another house, buying specified exemption bonds with a lock-in, and paying the tax and investing freely, on after-tax wealth over five years.

The situation

Leela Sarkar-Mehta, 55, has sold an inherited flat in Kolkata for Rs 5 crore, a long-term gain of Rs 3 crore. She already owns the home she lives in. Indian tax law offers exemptions from tax on such gains if the money is reinvested in certain ways, each with its own conditions, caps and time limits, set out in specific sections of the Income Tax Act that change from time to time. Confirm every rule and figure below with a tax adviser before acting.

For the case, use illustrative figures: 12.5% tax on the long-term gain; route A, buying another residential flat with the Rs 3 crore gain, exempts it fully, the flat rising 5% a year with a 2% net rent and 2% selling costs; route B, specified bonds capped at Rs 50 lakh, locked for five years, paying 5.25% taxed at her 30% slab; route C, pay the tax and invest. Free money earns 10% a year, taxed at 12.5% on the gain when sold.

Your task

Compare the three routes on after-tax wealth at year 5, show how sensitive the ranking is, and say what each route costs in flexibility.

Quick check

Which route saves the most tax up front?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

At the illustrative 10% return, paying the tax ends slightly richest, Rs 7.10 crore, against Rs 7.06 crore for the house and Rs 7.02 crore for the bonds. The totals sit within about Rs 8 lakh, so flexibility decides. The house saves the most tax but ties Rs 3 crore to one property; the bonds only beat paying the tax if free money earns under about 7.0% a year. An exemption is worth only what it costs in flexibility.

Step 1Why is the biggest tax saving not automatically the best route?

A shop's festival discount is only a saving if you wanted the thing anyway. Each exemption saves tax by steering the money into a particular asset, so its value is the tax saved minus whatever that asset earns less than, or locks up longer than, the alternative. Route A saves Rs 37.5 lakh of tax but puts Rs 3 crore into one flat. Route B saves Rs 6.25 lakh but locks Rs 50 lakh at a low taxable rate. Route C saves nothing and keeps every rupee free.

Step 2How do the three routes compare at year 5?

Run each to year 5 and sell everything, so the comparison is after all tax. At 10% on free money, route C ends at Rs 7.10 crore, route A at Rs 7.06 crore and route B at Rs 7.02 crore. The bonds lose because 5.25% taxed at 30% nets about 3.7% a year, far below 10%, and that gap outweighs the Rs 6.25 lakh saved. The house route nearly ties, because the flat earns about 7% a year all in, and the untaxed Rs 37.5 lakh is working inside it.

Wealth after tax at year 5, Rs crore: close totals, very different flexibility7.058Buy another houseRs 3 crore in a flat,harder to sell7.016Exemption bondsRs 50 lakh lockedfor five years7.096Pay the taxall Rs 4.6 crorefree to movebars start at Rs 6.8 crore, not zero
At an illustrative 10% return on free money, paying the tax ends at Rs 7.10 crore after all tax at year 5, the house route at Rs 7.06 crore and the bond route at Rs 7.02 crore, so the totals are close and the lock-ins decide.
Return on free moneyA: houseB: bondsC: pay tax
6%6.5826.0195.994
8%6.8116.4996.524
10%7.0587.0167.096
12%7.3247.5737.710
Rs crore at year 5, after all tax. The house route beats paying the tax unless free money earns more than about 9.8%, because the untaxed Rs 37.5 lakh works inside the flat; the bonds beat paying the tax only below about 7.0%.
Step 3So which route suits Leela?

The ranking turns on the return assumption, so decide on flexibility. Route A only makes sense if Leela wants a second property anyway, because it concentrates Rs 3 crore in one illiquid asset for years to save Rs 37.5 lakh. Route B is a small, low-regret choice for money she would hold in debt anyway. Route C is right if she values the freedom to rebalance, fund needs or change her mind. A mix, bonds for part and tax paid on the rest, is often the honest answer. Every figure here must be checked against current rules first.

Where candidates lose it

Candidates compare tax saved, Rs 37.5 lakh against Rs 6.25 lakh against zero, and pick the house. That skips what the money earns after the saving, which is where the ranking is actually decided.

The second miss is quoting exemption limits and lock-in periods from memory as fact. Name the framework, use the figures as illustrations, and say the current rules must be confirmed.

What the interviewer asks next

  • Leela might need Rs 1 crore for a family wedding in year 2. How does that change the choice?
  • What happens under route A if she sells the new flat within the lock-in period?
  • How would you split the Rs 5 crore across the routes if she wanted some of each?

Company names and figures are illustrative.