Investing in mutual funds for the long term can build substantial wealth, but the real challenge comes when it’s time to redeem your investment. After 15–20 years, your mutual fund value might have multiplied several times, and that means you could face significant long-term capital gains tax. The good news is that the Income Tax Act in India allows several legal ways to save or minimize tax on these profits if you plan your next financial move wisely.
In this guide, you’ll learn how you can save tax on mutual fund redemptions by buying or constructing a house, investing in government bonds, and exploring other legitimate tax-saving options under different sections of the Income Tax Act.
Understanding How Mutual Fund Gains Are Taxed
Before diving into tax exemptions, it’s essential to understand how mutual fund gains are categorized and taxed in India. Mutual fund taxation depends on two key factors — the type of fund and the duration of holding.
1. Equity Mutual Funds
- If held for more than 12 months, the gains are treated as Long-Term Capital Gains (LTCG).
- LTCG up to ₹1 lakh per financial year is tax-free, and anything above that is taxed at 10% without indexation.
- Short-term gains (held for less than 12 months) are taxed at 15%.
2. Debt, Hybrid, or Gold Mutual Funds
- If held for more than 36 months, the gains are Long-Term Capital Gains taxed at 20% with indexation benefits.
- The indexation benefit adjusts your purchase cost for inflation, reducing your taxable gain amount.
- If redeemed before 36 months, they are short-term gains and added to your income, taxed as per your income slab
Understanding this classification helps you choose the right exemption route when you redeem your funds.
Save Tax on Mutual Fund Gains by Buying a House Under Section 54F
One of the most effective ways to save tax on mutual fund gains is by investing the proceeds into a residential house. This falls under Section 54F of the Income Tax Act, 1961.
What is Section 54F?
Section 54F allows a complete or partial exemption on long-term capital gains arising from the sale of any capital asset other than a residential house, provided the proceeds are invested in buying or constructing a residential property in India.
Key Conditions to Claim Section 54F Exemption
- Type of Asset – The capital gain must come from a capital asset such as mutual funds, gold, land, or shares, excluding a house property.
- Investment Timeline – You can buy a new house within 1 year before or 2 years after the sale, or construct a house within 3 years after the sale.
- Number of Houses Owned – You should not own more than one residential house (excluding the new one purchased).
- Usage – The new house must be purchased or constructed in India.
- Lock-in Period – The property must be held for at least 3 years. Selling it before that will revoke the exemption.
How the Exemption Works
- If you invest the entire sale proceeds, your entire capital gain is exempt from tax.
- If you invest only part of the proceeds, the exemption applies proportionately using this formula: Exemption = (Amount Invested / Net Sale Proceeds) × Capital Gain
Example:
Suppose you redeem mutual funds worth ₹40 lakh after 20 years and your capital gain is ₹20 lakh.
If you buy a new residential house worth ₹40 lakh, the entire ₹20 lakh capital gain becomes tax-free under Section 54F.
If you invest only ₹20 lakh in a house, then only 50% of your capital gains (₹10 lakh) will be exempt.
Save Tax by Investing in Government Bonds – Section 54EC
If you do not wish to buy a house, there’s another legitimate way to save tax through Section 54EC. This allows you to reinvest your capital gains (not the full sale amount) in specified government bonds.
What Are 54EC Bonds?
These are capital gain bonds issued by:
- National Highways Authority of India (NHAI)
- Rural Electrification Corporation (REC)
- Power Finance Corporation (PFC)
- Indian Railway Finance Corporation (IRFC)
Key Rules:
- You must invest within 6 months of redeeming your mutual funds.
- The maximum amount eligible for exemption is ₹50 lakh.
- The bonds have a lock-in period of 5 years.
- Interest earned on these bonds is taxable, but your capital gain is exempt up to the invested amount.
This option is ideal for those who prefer a safe and hassle-free investment without buying property.
Use the Capital Gains Account Scheme (CGAS)
If you haven’t yet decided how to reinvest your redemption amount, you can temporarily park it in a Capital Gains Account Scheme (CGAS).
Under this scheme, you can deposit your sale proceeds into a special account with a public sector bank before the due date of your income tax return (usually July 31 of the next year). Later, you can withdraw this amount to buy or construct a house or invest in 54EC bonds.
If the deposited amount is not utilized within the allowed period (2 years for purchase or 3 years for construction), it becomes taxable in that year.
Redeem Smartly to Use the ₹1 Lakh Tax-Free Limit
For equity mutual funds, LTCG up to ₹1 lakh per year is exempt from tax. Instead of redeeming your entire investment in one year, consider redeeming gradually over multiple financial years. This strategy helps you make the most of the ₹1 lakh exemption every year, effectively reducing your taxable gains.
This approach works best for investors planning systematic withdrawals during retirement or over a few years.
Offset Gains Against Losses
If you’ve incurred losses from other investments like shares, property, or debt mutual funds, you can set off those losses against your mutual fund gains.
Here’s how it works:
- Short-term capital losses can be set off against both short-term and long-term gains.
- Long-term capital losses can be set off only against long-term gains.
- If your losses are not fully utilized, they can be carried forward for up to 8 years, helping you minimize future tax liability.
Diversify to Balance Tax Impact
While tax saving is important, long-term investors should also look at diversifying their portfolio across equity, debt, and hybrid funds. Diversification helps manage risk and provides flexibility at the time of redemption. It also allows you to plan redemptions smartly based on tax advantages available for each asset type.
Summary of Tax-Saving Options on Mutual Fund Redemption
| Strategy | Section | Maximum Limit | Time to Invest | Lock-in | Suitable For |
|---|---|---|---|---|---|
| Buy or Construct a House | 54F | No upper limit | 1 year before or 2–3 years after sale | 3 years | Long-term investors looking for a home |
| Invest in Govt. Bonds | 54EC | ₹50 lakh | Within 6 months | 5 years | Safe, risk-free investors |
| Capital Gains Account Scheme | CGAS | No limit | Before ITR due date | As per use | Those awaiting reinvestment decision |
| Redeem in Phases | – | ₹1 lakh per year tax-free | Ongoing | None | Equity MF investors |
| Offset Losses | – | NA | Same or future years | NA | Those with capital losses |
FAQs
1. Can I save tax on mutual fund gains by buying a house after 20 years?
Yes. Under Section 54F, you can save tax by investing your mutual fund redemption proceeds into a residential house within the specified timelines. The entire capital gain can be exempt if you reinvest the full sale amount.
2. What if I only reinvest part of my mutual fund proceeds in a house?
You’ll get a partial exemption under Section 54F, calculated proportionately based on how much you reinvest out of the total sale amount.
3. Is it necessary to buy the house before redeeming the mutual funds?
Not necessarily. You can buy the house within one year before or up to two years after the redemption date. For construction, you get three years after the sale date.
4. What happens if I don’t buy a house or invest within the deadline?
You can temporarily deposit the amount under the Capital Gains Account Scheme (CGAS) before filing your ITR. If you don’t use it within the specified time, it becomes taxable in the year the period expires.
5. Can I claim tax exemption if I buy the house jointly with my spouse or parent?
Yes, you can, but the exemption will be available only to the extent of your ownership share in the property. It’s best to purchase the house in your name for a full exemption benefit.
Final Thoughts
Selling mutual funds after 20 years can bring significant long-term capital gains, but smart planning can help you save a large part of the tax legally. Whether you choose to buy a new house under Section 54F, invest in government bonds under Section 54EC, or strategically redeem your funds, each route can protect your wealth while staying fully compliant with tax laws.
Please note: The rules and eligibility conditions can vary based on individual circumstances. It’s always recommended to consult a certified financial advisor or chartered accountant to understand your exact tax liability and the most suitable exemption route for your situation. So do discuss with them upfront, as some might not give you ideas.