[Opinion] Self-Created Encumbrances in Capital Gains Taxation

Hemlata Mali – [2026] 186 taxmann.com 276 (Article)

1. Introduction

Capital gains taxation in India has always operated on a relatively straightforward premise – the seller is taxed on the difference between what she received and what the asset cost her, with certain permitted deductions. What the law has never permitted, and what courts have consistently refused to allow is a deduction for obligations the seller herself created voluntarily after acquiring the asset. This judicial position, developed over six decades of litigation, is what practitioners and tribunals have come to call the self-created encumbrance bar.

This article examines how the doctrine operates, traces its development through landmark rulings of the Supreme Court, the Allahabad High Court, and the Chennai Bench of the ITAT, and demonstrates why the Income Tax Act 2025 (ITA 2025) which consolidates and re-numbers the provisions of the 1961 Act carries the entire framework forward unchanged.

Two questions lie at the heart of the discussion:

When does clearing an encumbrance qualify as a deductible expenditure in connection with a transfer?
Why does the answer change completely when the assessee herself is the one who created the encumbrance?

2. The Statutory Framework – What ITA 2025 Says

Section 67 of ITA 2025 corresponds to the former Section 48(i) of the 1961 Act. It permits a deduction from sale consideration for expenditure incurred wholly and exclusively in connection with the transfer of a capital asset. Brokerage, legal charges, and stamp duty fall naturally within this head.

Section 68 of ITA 2025 corresponds to the former Section 48(ii). It allows a deduction for the cost of acquisition and cost of improvement. Payments made to clear a third party’s pre-existing charge on a property have historically been treated as part of the cost of acquisition under this head.

What neither provision does, and what the courts have repeatedly confirmed is extend deductibility to obligations the assessee voluntarily brought into existence. The phrase ‘wholly and exclusively in connection with the transfer’ is not a blank cheque. It requires that the expenditure be genuinely incidental to the act of transfer, not a payment toward a liability the seller built and then conveniently discharged at the point of sale.

3. The Foundational Rule – Who Created the Mortgage?

The governing principle was laid down by the Supreme Court in V.S.M.R. Jagadishchandran v. CIT [1997] 93 Taxman 389 (SC)/[1997] 227 ITR 240 (SC). The assessee sold properties that were subject to a mortgage he had himself created. The buyer discharged the mortgage out of the sale proceeds. The assessee claimed the repayment as either a cost of acquisition or a cost of improvement.

The Supreme Court dismissed the claim on a single, decisive question – who created the mortgage? The Court explained the distinction with precision:

If a predecessor mortgages property during his lifetime and the heir inherits only the mortgagor’s limited interest, then paying off that debt acquires the mortgagee’s interest in the property. That payment is a cost of acquisition, something new is being acquired.
If the owner himself creates the mortgage on property he already owns free of encumbrances, clearing it acquires nothing new. He is simply repaying his own debt. No deduction is available.

“The position is different where the mortgage is created by the owner after he has acquired the property. The clearing off of the mortgage debt by him prior to transfer would not entitle him to claim deduction under Section 48.”

— Supreme Court, Jagadishchandran (1997)

The Allahabad High Court applied the parallel diversion versus application framework in CIT v. Sharad Sharma [2007] 169 Taxman 67 (Allahabad)/[2008] 305 ITR 24 (Allahabad). Sharad Sharma had mortgaged his personal house to secure his firm’s bank loan. When the bank auctioned the property and recovered Rs. 1,50,000 out of Rs. 1,95,000 in proceeds, Sharma argued the bank had an overriding title that diverted the income before it reached him.

The High Court rejected this. A self-created mortgage does not give the creditor an overriding title that intercepts income at its source. The sale consideration first accrues to the seller; he then chooses to pay off his own liability from it. That is an application of income—and it is taxable in full.