Starting construction before selling the old house does not automatically block Section 54 tax exemption, but courts focus on completion timing, not the start date.
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Starting construction of a new house before selling an existing residential property does not automatically rule out a Section 54 exemption. The timing of completion, not the start date, is what courts have focused on, lawyers said.
Saurabh Kumar, Managing Partner at SK Attorneys, said Section 54 helps reduce or avoid capital gains tax on the sale of a residential property held for more than 24 months. The exemption is available to an individual or HUF on long-term capital gains from a residential house sale, said Varad Kale, Partner at V.V. Kale & Company. It can be claimed by constructing a new house within three years after the sale.
Kale added that the exemption is generally the lower of the capital gain or the amount invested, capped at ₹10 crore. Where the gain does not exceed ₹2 crore, the taxpayer has a one-time lifetime option to invest in two residential houses instead of one.
Can construction start before the sale?
Yes. Kale noted that Section 54 does not prescribe a specific period for starting construction before the sale. However, in his view, construction should not begin more than one year before the sale, as this could invite litigation.
Kumar added that there is no time limit on how early construction may begin. Courts have focused on the completion date rather than the date construction started. Section 54 distinguishes between commencement and completion. If construction starts before the sale but is completed within three years after the sale, the exemption can still apply.
The taxpayer should have evidence that the house was completed and ready for use within the three-year period.
What can disqualify the exemption?
Kumar said the exemption can be denied if the seller is not an individual or HUF, or if the new house is sold within three years.
Kale stated that the exemption can be affected to the extent the capital gain remains unutilised. Any amount not utilised within the prescribed period can become taxable.
Kumar explained that if the new house is not completed within three years, any unutilised capital gains account scheme (CGAS) balance is treated as long-term capital gain in the year the three-year period expires, under Section 54(2). This is a statutory tax consequence, not a penalty.
Kale explained that any unutilised capital gain by the Section 139(1) return-filing due date should be deposited in CGAS and subsequently used for eligible construction within three years. Payments should be made from CGAS as prescribed.
He added that eligible construction payments made from the taxpayer's own funds before the CGAS requirement arises can potentially count as utilisation, depending on the facts and supporting evidence.
When construction is complete before the sale
Kumar noted that if construction is fully completed before the sale, the three-year construction rule does not apply. Instead, it must qualify as a purchase within one year before the sale.
"Finishing it more than 1 year prior makes it an existing asset, which can disqualify you if you own other properties," he said.
Taxpayers should maintain a clear evidentiary trail, including documents showing the start and completion of construction, Kumar said.
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