In a significant decision for property owners, the Income Tax Appellate Tribunal (ITAT) Mumbai bench has clarified that two adjacent residential flats, when legally and physically merged, can be treated as a single house for the purpose of claiming tax exemptions under Section 54 of the Income Tax Act. This ruling, issued on August 17, 2026, dismisses a challenge from the tax department, affirming a taxpayer's right to full exemption on capital gains exceeding the standard threshold for multiple properties.
Understanding Section 54 Capital Gains Exemption
Section 54 offers crucial tax relief on long-term capital gains earned from the sale of a residential house property held for over 24 months. To qualify for this exemption, the capital gains must be reinvested in the purchase or construction of another residential house. This reinvestment must occur either one year before or two years after the sale of the original property.
However, rules applicable from Assessment Year 2021-22 introduced a limitation: taxpayers can claim Section 54 exemptions on two separate residential properties only if the total capital gains do not exceed ₹2 crore. This threshold often creates complexities for high-value transactions or investments across multiple units.
The Mumbai Case: A Precedent-Setting Challenge
The ITAT's ruling stems from a case involving a prime residential property in Malabar Hill, Mumbai, which was sold for ₹43 crore. The sale generated long-term capital gains of ₹26.59 crore for the Assessment Year 2021-22. Seeking to mitigate the tax burden, the owner reinvested the entire proceeds into two adjacent flats, Flat Nos. 3101 and 3102, located in Lower Parel, Worli, claiming a full exemption under Section 54.
Tax Department's Contention
The tax department, through its Assessing Officer, contested this claim. They argued that the adjacent units were distinct properties, not a single house. Given that the capital gains far exceeded the ₹2 crore threshold, the officer limited the tax exemption to ₹22.56 crore (for Flat No. 3102), imposing capital gains tax on the remaining ₹4.03 crore attributed to Flat No. 3101.
Legal Merger and ITAT's Verdict
To formalize the arrangement, the property owner executed a registered supplementary agreement with the developer on March 25, 2022. This agreement legally merged Flat No. 3101 into Flat No. 3102, effectively creating a single, composite residential unit.
The Commissioner of Income Tax (Appeals) reviewed this supplementary agreement and other financial records, ultimately ruling in favor of the taxpayer. The tax department then escalated the matter to the Mumbai bench of the ITAT.
The ITAT, in its August 17, 2026 order, upheld the Commissioner's decision. The Tribunal emphasized that since the two adjacent flats were both physically and legally merged into one composite residence, they indeed constituted a single house. Consequently, the restrictions governing investments in two separate properties did not apply, and the full ₹26.59 crore exemption was allowed. This landmark ruling provides clarity for taxpayers considering similar property consolidation strategies.