Case Reference: Nilesh Ramesh Modi v. The Income Tax Officer, Ward 16(3)(1), Mumbai & Ors.
Court: Bombay High Court
Case Number: Writ Petition No. 4898 of 2026
Decision Date: 2 November 2026
Introduction
The Bombay High Court has held that the Income Tax Department cannot add the entire purchase cost of a second residential flat to a taxpayer’s taxable income while computing capital gains under Section 54F of the Income Tax Act, 1961, merely because the exemption claimed in respect of that flat has been denied.
The Court clarified that rejection of an exemption claim does not authorise the Assessing Officer to adopt an incorrect method of computing capital gains. The computation must strictly follow the statutory provisions governing capital gains taxation.
The judgment provides important guidance on the correct computation of capital gains where an assessee invests the sale proceeds in more than one residential property.
Facts of the Case
The petitioner had sold certain tenancy rights and shares and utilised the proceeds to purchase two adjoining residential flats in Mumbai.
He claimed exemption under Section 54F of the Income Tax Act, 1961, contending that both flats were purchased with the intention of using them together as a single residential house.
However, the Income Tax Department treated the two flats as separate residential units and allowed the exemption in respect of only one flat.
While computing the taxable capital gains, the Department additionally included the entire purchase cost of the second flat, amounting to approximately ₹4.78 crore, in the petitioner’s taxable income.
Consequently, the Department computed the capital gains at approximately ₹13.24 crore, which, according to the petitioner, even exceeded the total consideration received from the transfer of the original assets.
The petitioner challenged this computation and requested rectification. However, the Department rejected his request and directed him to deposit ₹38.75 lakh as a condition for obtaining a stay on recovery of the outstanding tax demand.
Legal Issue Before the High Court
The principal issue before the Court was whether the Income Tax Department could add the entire purchase cost of the second residential flat to the taxable capital gains merely because the exemption under Section 54F was not allowed in respect of that property.
The Court was also required to examine whether the Department’s computation of capital gains was consistent with the statutory formula prescribed under Section 54F.
Observations and Findings of the Court
A Division Bench comprising Justice B.P. Colabawalla and Justice Farhan P. Dubash examined the computation adopted by the Income Tax Department.
The Court found that the Department’s decision to add ₹4,78,45,668, representing the purchase price of the second flat, to the taxable capital gains was manifestly incorrect.
The petitioner had submitted a revised computation demonstrating that, after applying the provisions of Section 54F(1)(b), the correct capital gains would amount to ₹2,93,47,526.
Importantly, the Revenue did not dispute this revised computation.
The Court observed that the plain language of Section 54F supported the petitioner’s computation and that the Department had failed to justify its calculation of capital gains at ₹13.24 crore.
The Bench, therefore, held that the entire purchase cost of the second flat could not be mechanically added to the taxable income.
Whether Two Flats Can Be Treated as One Residential House?
An important aspect of the judgment was the Court’s clarification regarding the scope of its decision.
The petitioner had contended that the two adjoining flats were intended to be used as a single residential house and, therefore, qualified for exemption under Section 54F.
However, the High Court expressly refrained from deciding whether the two adjoining flats could legally be treated as one residential house for claiming exemption under Section 54F.
The question was left open for consideration by the appellate authority while deciding the petitioner’s pending appeal.
Thus, the judgment does not establish that two adjoining flats automatically qualify as one residential house for Section 54F exemption.
Final Decision of the High Court
The Bombay High Court granted partial relief to the petitioner by reducing the pre-deposit requirement for obtaining a stay of recovery from ₹38.75 lakh to ₹6.50 lakh.
The Court further stayed recovery of the remaining tax demand of approximately ₹32.24 lakh pending disposal of the petitioner’s appeal and for four weeks thereafter.
The Commissioner of Income Tax (Appeals) was also requested to dispose of the pending appeal expeditiously.
Legal Significance of the Judgment
This decision reinforces an important principle of income tax assessment: denial of a tax exemption does not permit the Assessing Officer to adopt an arbitrary or legally unsustainable computation of taxable income.
Where an exemption under Section 54F is denied, the taxable capital gains must nevertheless be calculated in accordance with the statutory formula prescribed under the Act.
The judgment is particularly relevant in cases involving investment in multiple residential properties, disputes concerning Section 54F exemptions and challenges to excessive capital gains demands.
It also highlights that taxpayers can challenge an erroneous computation independently of the substantive dispute concerning their eligibility for exemption.
The key takeaway is that rejection of a Section 54F exemption cannot justify an artificial inflation of taxable capital gains by adding the entire purchase cost of the residential property to the assessee’s income.