Should You Still Invest Into 54EC Bonds?

If you’re in the process of finalizing a sale of your property, you’re probably considering 54EC bonds as an option to save long term capital gains taxes. But since returns from these bonds are fairly low are 5.75%, many investors do not consider them a worthy option; especially after the mandated lock in period was increased from three years to five, in 2018. Should you park your long-term capital gains into them nevertheless, or invest someplace else? Here are a few points to consider.

The interest from 54EC bonds are taxable as normal income, and the maximum amount you can invest in each Financial Year is restricted to Rs. 50 Lakhs. The effective post-tax interest rate of return earned works out to roughly 4% to 5% depending upon the marginal tax rate applied (between 10% and 30%).

Before you’re instantly put off by the low post-tax return on these bonds, consider the actual ‘rate of return’ you’ll be earning from them after factoring in the taxes saved, and make an ‘apples to apples’ comparison with your other investment options thereafter.

Say, you’ve earned a long-term capital gain of Rs. 100. All things kept unchanged; you’ll need to shell out Rs. 20 as LTCG (Long Term Capital Gains Tax) in the year that the transaction was booked. That would leave you with Rs. 80 to invest.

If, on the other hand, you decide to invest into 54EC bonds (even at the low rate of interest), you’ll save yourself a tax outgo of Rs. 20, and receive a post-tax interest ranging from Rs. 4 to Rs. 5 each year for the next five years, depending upon your tax bracket.

The best way to draw up a cash flow table for this scenario would be as such: assume Rs. 100 as the initial investment, Rs. 20 (the amount of tax outgo saved) as a positive cash flow in the first year, and the annual interest pay-outs each year as positive cash flows for the next five years – with a principal repayment in the 5th year from the date of investment.

Surprisingly, this works out to an IRR (Internal Rate of Return) of more than 9.16% for the worst-case scenario - that is, assuming the highest tax bracket. For the best-case scenario (a marginal tax rate of 10%), it works out to roughly 10.32%. Admittedly, these IRR’s were significantly better when the mandated lock in period for these bonds was three years, but given that 54EC bonds are backed by the government and hence default risk-free - a guaranteed, post tax IRR of 9.16% isn’t too shabby. So, unless you’re an aggressive risk taker who expects returns significantly higher than 10% CAGR for the next five years from equities, it would be a wise move to steer your ship towards the safe port of call that is 54EC, low rates notwithstanding. Remember that under current tax laws, long term capital gains from equities is taxable as well.