Using ITR-1 after selling shares and not reporting capital gains tax? Here's when you may need ITR-2 instead

I sold some equity shares and equity mutual funds during FY26. My long-term capital gains are below the ₹1.25 lakh exemption limit under Section 112A, so I assumed I don't have to report them in my income tax return. Can I still file ITR-1, or do I need to use ITR-2? If I don't disclose these tax-exempt capital gains because no tax is payable, could it create issues with my AIS or Form 26AS, delay my refund, or lead to a tax notice later? What is the correct way to report such gains while filing my ITR?

Advice by CA Chhayank Thakur, Internal Audit Officer at PSU of Oil Manufacturing Company

Many taxpayers believe they can continue filing ITR-1 if their long-term capital gains (LTCG) from listed shares or equity mutual funds are below the ₹1.25 lakh tax-exemption limit. However, tax experts caution that eligibility for an ITR form depends on the nature of income, not whether tax is payable. Choosing the wrong return form could result in a defective return, refund delays or additional compliance issues. Here's when investors must opt for ITR-2, why exempt capital gains may still need to be reported, and the common filing mistakes to avoid.

1. Many taxpayers believe they don't need to file an ITR if their long-term capital gains (LTCG) are below ₹1.25 lakh because no tax is payable. Is that correct, and what does the law actually require?

The greatest fallacy is to think that "having no tax due" and "not reporting one's income" are the same. To clarify, the ₹1.25 lakh limit described in Section 112A releases the person from having to pay tax on specified long-term capital gains; however, it does not mean that the person is free from making an ITR.

MUST READ: Received FD interest this year? Here's how to calculate your tax liability before filing ITR

In cases where an individual fulfills certain conditions that would make him/her liable for filing the income tax return—whether because of income amount, large financial transactions or other reasons—he/she has to inform the income tax authorities about the long-term capital gains that he/she obtains even if it happens that no tax is due. Thus, from a legal point of view, ITR is a document declaring the income instead of just a form for paying taxes. The data on capital gains is forwarded from stock exchanges, mutual funds as well as registrar and depository institutions to the income tax department. If the transactions are omitted because of no income tax due, it may create the situation when data differs from tax payer's data.

2. Can taxpayers with LTCG below ₹1.25 lakh use ITR-1, or are there situations where they must file ITR-2 instead? What are the common mistakes people make while choosing the ITR form?

For an ITR form to be applicable, it is essential to consider the kind of income and not only the tax liability of the individual.
One of the commonest mistakes that most people make is thinking that ITR-1 remains applicable when there is no taxable LTCG. What is important is that people should assess their eligibility for the ITR forms under the provisions of law and this can entail a lot of work especially for people with capital gains. The other major mistake is failing to choose the correct form of income tax return. This is because many people tend to choose the easiest form rather than the one which is suitable in accordance with the law. If a person uses an incorrectly filled return form, chances are that his application will be labeled as defective thus making it impossible to process one's refund.

MUST READ: TDS deducted from salary but missing in Form 26AS? What the law says about your tax liability

3. What are the consequences of not reporting tax-exempt LTCG in the ITR? Can it lead to notices, issues with AIS/Form 26AS reconciliation, or problems in future assessments?

Failing to report taxable LTCG could seem innocuous as there would be no immediate tax liability to face, yet this omission could create needless compliance issues. The Income Tax Department is now predominantly relying on information received from various entities like exchanges, mutual funds, registrars, etc. When capital gains are reported in the AIS or any other information but have not been included in one's income tax return, then the discrepancies will be flagged by the information technology system to check for any wrongdoings. Though not all discrepancies would incur a notice from the department but every such episode will increase the chances of queries and clarifications.

In addition to notices, non-compliance could create a lot of trouble for the respondent at the time of proving the original investment cost, ascertaining the eligibility for grandfathering, determining further gains, or backing up of such previous transactions later on during assessments.

MUST READ: Selling a property this year? Why the new 12.5% capital gains tax may not always reduce your tax bill