When someone sells their home and makes a profit, it’s usually followed by a hefty capital gains tax. But what if that money could go into building the next big startup — and the tax just disappeared?
That’s the idea behind Section 54GB of the Income Tax Act. Introduced to support the startup ecosystem, this provision offers a way for individuals and HUFs (Hindu Undivided Families) to claim capital gains exemption — if they invest those gains into an eligible startup.
In this 6th edition of the M2K Startup Series, we break down this exemption in plain terms: how it works, who qualifies, what conditions must be met, how the exemption is calculated, and what happens if the conditions are broken.
Capital Gains Tax Exemption on Investment in Startups
To make startup investments more attractive, especially for individuals who’ve sold a residential property, the Finance Act 2016 brought in an amendment to Section 54GB. This allowed long-term capital gains from the sale of a residential property to be exempt from tax, provided those gains were invested into a startup by purchasing its equity shares.
But this isn’t an open-ended exemption. Several strict conditions need to be met — both by the investor and the startup — for the benefit to apply.
Also, this exemption is not available for residential property sales that happened after 31st March 2022.
Provisions applicable to start-ups
Section 54GB says that individuals or HUFs can get an exemption on capital gains made from selling a residential property — if they use those proceeds to subscribe to equity shares of an eligible company.
So, what makes a company “eligible”?
All of the following conditions must be met:
- The company must be incorporated between the start of the previous year in which the capital gain arises and the due date for filing the income tax return.
- It must be an “eligible startup” engaged in an “eligible business” (these terms were defined earlier in Startup Series #2).
- The individual or HUF must invest more than 25% of the share capital or voting rights in that company.
The exemption kicks in only when all three conditions are satisfied.
Again, to emphasise: if the residential property was sold after 31st March 2022, this benefit is no longer available.
Conditions to be satisfied for claiming exemption
There are multiple time-sensitive and compliance-heavy steps that must be followed for the exemption to hold:
- The net sale proceeds from the residential property must be invested in the equity shares of an eligible startup before the due date of filing the income tax return.
- Once the investment is made, the startup must use that money to buy new assets — within one year from the date of equity subscription.
- If the startup hasn’t used the full amount before the tax return due date, the remaining balance must be deposited into a Capital Gains Account Scheme. Proof of this deposit must be submitted along with the investor’s income tax return.
- The cost of new assets, including the amount deposited in the Capital Gains Scheme, will be treated as the “cost of new asset” for exemption purposes.
- Both the equity shares held by the investor and the new assets acquired by the startup must not be transferred for five years.
There’s an exception: if the new asset is computer or software, and the startup is a technology-driven startup certified by the Inter-Ministerial Board of Certification (IMBC), the holding period is three years, not five.
So while the idea is simple — invest your sale gains into a startup — the actual process comes with very specific timelines and restrictions.
Conditions to be satisfied for claiming exemption
Let’s clarify what qualifies as a new asset under this rule. It’s not just any purchase.
The term “new asset” specifically refers to new plant and machinery (P&M). But several things are not included in this definition:
- Any machinery that was used before, either inside or outside India
- Machinery or equipment installed in residential premises, guest houses, or office premises
- Vehicles of any kind
- Office appliances, including computers and software
- Any plant and machinery whose entire cost is already claimed as a deduction, either through depreciation or otherwise
This means the startup can’t just use the invested money for any operational purchase and expect to retain the tax exemption. The spending must go toward qualifying assets only.
Quantum of exemption u/s 54GB
How much capital gains tax can be exempt under this provision? The math is straightforward but depends on one key comparison: net consideration vs. cost of new assets.
Let’s look at the illustration from the PDF:
| Particulars | Case 1 | Case 2 |
| Net consideration (A) | ₹800L | ₹800L |
| Cost of acquisition (B) | ₹500L | ₹500L |
| Long-term capital gain (C) = A – B | ₹300L | ₹300L |
| Cost of new asset (D) | ₹500L | ₹800L |
| Exemption (E) = C × D/A | ₹187.5L | ₹300L |
| Capital gain taxed (C – E) | ₹112.5L | ₹0L |
Case 1: Cost of new asset < Net consideration
Only a part of the gain is exempt, based on the proportion of asset cost to net sale amount.
Case 2: Cost of new asset ≥ Net consideration
The entire capital gain is exempt.
So the exemption is either full or proportional, depending on how much of the sale money is reinvested.
Consequences of default
Now comes the tricky part: what happens if the conditions are broken?
There are two major types of default, and each has tax consequences:
1. Startup doesn’t use the funds within 1 year
If the startup fails to use the invested funds (or only uses part of it) within one year, then:
- The difference between the exemption actually claimed and what should have been claimed (based on actual asset purchase) becomes taxable as capital gain.
- This is taxed in the year when the one-year period for acquiring assets ends.
So if the startup delays or misses using the funds, the investor ends up paying tax later — even if they did everything right on their end.
2. Startup or investor sells too early
If either of the following is transferred before the holding period ends (five years or three years in specific cases), then:
- The exemption originally allowed will be revoked, and
- The full amount becomes taxable as capital gain in the year of transfer.
This applies in two scenarios:
- The startup sells the new asset
- The investor sells the equity shares
So it’s critical that both the investor and the startup stick to the agreed timeline. Any premature exit means the tax holiday is lost, and the exemption is pulled back.
Final thoughts
This capital gains exemption under Section 54GB isn’t just a tax saving tool — it’s a strategic way to direct residential wealth into productive business capital. It rewards individuals who are willing to bet on entrepreneurship instead of reinvesting in real estate or other assets.
But it’s also one of the most condition-heavy benefits in the tax code. If you’re not careful, you could meet all the main requirements and still lose the exemption over a minor compliance issue.
To summarise:
- Investors must time their investment before the tax return filing due date
- Startups must use the funds within one year for eligible assets only
- Both the shares and assets must be held for five years (or three for tech startups)
- Even partial defaults can trigger full tax liability later
If you’re an investor considering this route — or a startup raising capital this way — get proper advice early. Because when structured correctly, this isn’t just a tax break. It’s a way to align long-term capital with long-term innovation.
