Tax on Advance forfeited on Property

Introduction:

It is quite general in the real estate transactions to receive advances against the sale of property from the buyer. The advance money is demanded by the seller from the buyer to ensure timely execution of the sale deed. But sometimes the transaction does not materialize as per the agreement due to the default of the buyer and the seller forfeits the advance money. A question arises as to the taxability of such advance money forfeited by the seller under the Income Tax Act, 1961. The Finance Act, 2014 which was presented by Arun Jaitley brought several amendments in the treatment of advance money so forfeited. In this article, we will discuss the treatment of advance money on property forfeited in the pre-amendment era and post-amendment era.

Amendment by Finance Act, 2014

Finance Act, 2014 inserted clause (ix) in section 56(2) of the Income Tax Act, 1961 which provides as below:

“Any sum of money received as an advance or otherwise in the course of negotiation for transfer of a capital asset, if, -

(a) Such sum is forfeited on or after 01-04-2014; and

(b) The negotiations do not result in transfer of such capital asset

Effect of the above amendment:

With effect from 01-04-2014, if any person (seller) receives any amount of money as an advance from the buyer in the course of negotiation for transfer of a capital asset and the amount is forfeited by such person (seller) due to default of the buyer with the terms of the agreement, the amount so forfeited shall be taxable in the hands of such person (seller). The seller will have to disclose such advance money forfeited under the head “Income from other sources” and the tax liability shall be discharged while income tax e-filing in the assessment year relevant to the year in which the advance money is so forfeited. Thus, the amount would be taxable as per the Income-tax Slab rates as applicable to the seller.

Position before 01-04-2014:

To understand the tax implication for advance money forfeited before 01-04-2014, we will first read the provisions of section 51 of the Income Tax Act, 1961, and then analyze the same in detail.

Section-51:

“Where any capital asset was on any previous occasion the subject matter of negotiations for its transfer, and any advance money or other money received is forfeited by the assessee, then the amount so forfeited shall be deducted from

(a) The cost for which the asset was acquired or

(b) The Fair Market Value (where the asset was acquired before 01-04-2001)

as the case may be, in computing the cost of acquisition”

Analysis of Section 51

Before 01-04-2014, if any advance money is received against the transfer of a capital asset and such advance money is forfeited, it is to be deducted from the cost of the capital asset or FMV of the capital asset, as the case may be for computation of indexed cost of acquisition, for the purpose of computing capital gain. In the case of a depreciable asset, the advance money forfeited is to be deducted from the written down value of such depreciable asset.

The effect of this provision was that the tax impact of the advance money forfeited used to get reflected in the year in which the asset was actually sold and not in the year in which advance money was forfeited. Further, the seller was not able to take benefit of indexation on the part of the cost of asset reduced due to advance money forfeited. The amendment made by Finance Act, 2014 has sorted out this issue. We will try to understand this by an example:

Example:

Ram has a residential house acquired in the year 1995 at Rs. 2 Lakhs (FMV Rs. 12 Lakhs on 01-04-2001). He received Rs. 3 lakhs as advance for the sale of property in the year 2003-04 which was forfeited by him due to default by the buyer. He finally sold the house in the financial year 2021-22 at Rs. 29 lakhs. Capital Gain Index: 2001 is 100 and for 2021-22: 317.

Solution:

Since advance money is received before 01-04-2014, the advance money forfeited Rs. 3 Lakhs will be deducted from the cost of asset or FMV for calculating the indexed cost of acquisition.

FMV of the residential House= 12 lakhs- 3 lakhs = 9 lakhs
Indexed cost for calculating capital gain = 9,00,000 * 317/100= Rs. 28,53,000

Long Term Capital Gain = 29,00,000 – 28,53,000 = Rs. 47,000 (taxable in FY 2021-22)

Thus, we can see that the advance money was forfeited in the year 2003-04 but the tax effect of the same is reflected in the year 2021-22 when the asset is actually sold by Ram. Thus, tax is chargeable on the advance money not in the year of receipt/ forfeiture but in the year in which the asset is sold.

Further, if there was no advance money, then indexing would have been done on the entire amount of Rs. 12 Lakhs (12 Lakhs * 317/100) = Rs. 38,04,000. Thus, there is a difference of Rs. 9,51,000 (38,04,000- 28,53,000) in the indexed cost of acquisition because of reduction of advance money forfeited Rs. 3 Lakhs. This resulted in a loss to the seller in form of a higher tax on the capital gain.

Therefore, the amendment was brought in section 51 by introducing a proviso and simultaneously introducing a new clause (ix) in section 56(2) to sort out the genuine problems of the sellers. Furthermore, the old section 51 was also used by certain people as an instrument to regulate unaccounted money. The amendment made by Finance Act, 2014 also removed such deficiencies in the law.

Finance Act, 2014 inserted proviso to section 51 as follows:

“Provided that where any sum of money, received as an advance or otherwise in the course of negotiations for the transfer of a capital asset, has been included in the total income of the assessee for any previous year in accordance with the provisions of section 56(2)(ix), then, such sum shall not be deducted from the cost for which the asset was acquired or the written down value or the fair market value, as the case may be, in computing the cost of acquisition.”

Net Impact of amendment:

If the seller had already forfeited any advance money prior to 01-04-2014, the same shall be deducted from the cost or FMV of the asset, as the case may be, to compute the cost of acquisition and thus capital gain.
But if the seller forfeits any advance money for the sale of the property on or after 01-04-2014, the same shall be considered as income under the head “Income from other sources” as discussed above in the article. The computation of capital gain will remain unaffected by the amount of advance money forfeited.
Tax impact in the hands of buyer: Forfeiture of advance money by the seller due to default on the part of the buyer, will not amount to relinquishment of a right in that asset. Therefore, the buyer will not be allowed to claim it as a capital loss under the head “Income from Capital Gains”.

We have discussed above the tax implications of the forfeiture of advance money in the ITR Return in the hands of the seller. However, there may be a case where the default is made by the seller and he makes payment of compensation to the buyer. In this case, it results in the relinquishment of the rights of the buyer. Therefore, the amount of compensation received by the buyer shall be taxed as capital gains.

Disclaimer: The above article is meant for informative purposes only and has no legal value. Readers are requested to act diligently and under consultation with any professional before applying the information contained in this article.

About Author: The above contribution is given by CA Naveen Goyal who is having experience of more than 15 years in the field of Direct Taxation (Income Tax) & Indirect Taxation. He has a deep interest in writing and sharing good stuff about taxation issues.

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