Merging two adjacent flats legally creates a single tax-exempt home. Here's what Section 54 says

A prime Malabar Hill residential property in Mumbai sold for ₹43 crore. The transaction left the owner with ₹26.59 crore in long-term capital gains for Assessment Year 2021-22. To shield the entire windfall from taxation, the owner reinvested the proceeds into two adjacent spaces — Flat Nos. 3101 and 3102 — at Lower Parel, Worli, claiming a full exemption under Section 54 of the Income Tax Act.

Tax department's challenge 

The tax department stepped in to contest the claim. The Assessing Officer treated the adjacent units as two distinct houses rather than one. Under rules applicable from AY 2021-22, a taxpayer can claim Section 54 exemptions on two separate residential properties only if total capital gains do not exceed ₹2 crore.

Because the gains in this case far exceeded that threshold, the officer capped the tax exemption at ₹22.56 crore for Flat No. 3102 and slapped capital gains tax on the remaining ₹4.03 crore spent on Flat No. 3101.

Structural Mergers & Appeals 

The property owner challenged the tax demand by formalising the structural setup of the units. On March 25, 2022, the owner executed a registered supplementary agreement with the developer to combine the properties. Flat No. 3101 surrendered its separate identity and was legally merged into Flat No. 3102, forming a single living unit.

The Commissioner of Income Tax (Appeals) reviewed the supplementary agreement alongside bank statements and ruled in favor of the taxpayer, prompting the tax department to take the matter to the Mumbai bench of the Income Tax Appellate Tribunal (ITAT).

The ITAT Verdict 

In an order pronounced on August 17, 2026, the ITAT dismissed the Revenue Department’s appeal. The Tribunal held that because the two adjacent flats were physically and legally merged into a single composite residence, they constituted one house. Consequently, the restrictions governing investments in two separate properties did not apply, and the Tribunal upheld the full ₹26.59 crore exemption.

Section 54 provides tax relief on long-term capital gains from selling a residential house held for over 24 months, provided the gains are reinvested in another residential house within one year before or two years after the sale.