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Any person who is selling real estate, shares, jewellery etc that is owned by him/her, needs to pay income tax on gains. Such gains are taxed under the head capital gains that arise out of such sale. Capital gains is nothing but profit on sale of capital assets. Capital assets are defined to include real estate, stocks, shares, bonds, jewelleries etc.

The income tax act defines what is capital gain and what kind of assets are covered for the purpose of taxing capital gains. It also provides for method for computation of capital gains.

Capital gains is divided into short term and long term capital gains depending upon the period for which an asset is being held and method of computation varies based on nature of capital gain. Method for computing the capital is as follows:

 

Short term capital gain Long term capital gain
Sale consideration                                 
Less: (a) Cost of acquisition                           (b) Cost of improvement                        (c) Expenditure incurred in                          connection with transfer                
Sale consideration                                    
Less : (a) Indexed cost of acquisition                 (b) Indexed cost of improvement              (c) Expenditure incurred in                                 connection with transfer           

 

Long term capital gain is computed by deducting indexed cost of acquisition and indexed cost of improvement.

 

1. What is Indexed Cost of Acquisition

Due to economic factors, value of asset / any item inflates over a period of time. A kg apple costs Rs 200 in 2018 but may have been available at less than half that price in 2001. Hence, it may not be fair to tax gains which is computed without factoring this inflation. Therefore, Cost Inflation Index (CII) are fixed by Government of India in its official Gazette to measure inflation and is used in computing long term capital gain in relation to sale of assets.. Indexation means adjustment in the cost of capital asset based on the CII. This inflated cost is considered to be the cost of acquisition while computing profit or loss on sale of capital asset. Thus, indexation helps reflect the actual value of the asset at present market rates, taking into account the erosion of value due to inflation. CII helps in saving tax by adjusting the purchasing price of the assets sold with the current market prices.

2. Computing Indexed Cost of Acquisition

Formula for computation of indexed cost of acquisition is as under:

Purchase Price of asset Sold x [CII for the year of sale ÷ CII for the year the asset was acquired or bought]

3. What is the base year?

Government has fixed a particular calendar year as base year and fixes the CII starting from base year. In case of assets acquired prior to base year, taxpayer has an option to choose either Fair Market Value (FMV) as on first day of base year or actual cost to arrive at indexed cost and compute capital gain/loss.

At present, base year is fixed at 2001 and CII for the base year starts at 100 and keeps increasing for each year. Further, taxpayer is allowed to claim deduction for cost of improvement incurred from base year onwards as FMV considered as on the starting day of base year itself accounts for cost of improvement undertaken prior to base year. FMV is an estimate of the market value of an asset such as property or gold, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. The FMV can be obtained from the Registered Valuer. As FMV is generally higher than original cost in case of most of the assets, taxpayer is benefitted by considering FMV to arrive at indexed cost of acquisition.

4. Shift of base year from 1981 to 2001

Prior to Finance Act 2017 base year for fixing CII was 1981 and Finance Act 2017 shifted base year from 1981 to 2001. Reason for shift of base year is considering the genuine hardship/difficulty that was placed on taxpayers in computing capital gain due to unavailability of relevant information for computation of FMV of assets as on 1 April 1981 which is more than 3 decades old.

Presently, base year is fixed at 2001 and CII for 2001 starts at 100.  Cost of acquisition of an asset acquired before 1 April 2001 shall be allowed to be taken as FMV as on 1st April, 2001 or actual cost as chosen by taxpayer and the cost of improvement shall include only those capital expenses which are incurred after 1 April 2001. Shifting the base year from 1981 to 2001 helps to capture the inflated cost of the property much better, lowering the capital gains and the tax burden.

Here is the CII notified by Government considering 2001 as base year

Here is the CII prior to Finance Act 2017 having base year as 1981

Note that this is no longer relevant for calculation of capital gains tax.

5. Impact of shift of base year

Though shift of base year is applicable to all capital assets, impact of the shift depends on the nature of asset and its appreciation in the value over a period of time. Long term capital gain would be less under base year 2001 if appreciation in price of asset is more than increase in CII between year of acquisition and 2001. Real estate owners who had acquired property prior to base year i.e., 2001 would probably benefit from shift in the base year because of high appreciation value of property.

Let us understand the same with the help of an illustration:

Mr A purchased capital asset for Rs 45 lacs in September 1990 sold the same for Rs 3 crores. Let us analyze the impact of the change under the following 3 scenarios:

  1. Sale is made during FY 2016-17 when the base year had not been shifted
  2. Sale made in FY 2017-18 after the base has been shifted to 2001 and where the FMV as on 1 April 2001 is greater than the Cost of Acquisition
  3. Sale made in FY 2017-18 after the base has been shifted to 2001 and where the FMV as on 1 April 2001 is lesser than the Cost of Acquisition

 

Particulars Scenario A Scenario B Scenario C
FMV as on 1.4.2001 Not Applicable 1,10,00,000 80,00,000
Sale consideration 3,00,00,000 3,00,00,000 3,00,00,000
(Less) Indexed Cost of Acquisition 2,78,15,934

(Purchase price * CII of 2016-17 / CII of 1990-91)

(45,00,000*1125/182)

2,99,20,000

(FMV * CII of 2017-18 / CII of 2001-02)
(1,10,00,000*272/100)

2,17,60,000

(FMV * CII of 2017-18 / CII of 2001-02)
(80,00,000*272/100)

Long Term Capital Gains 21,84,066 80,000 82,40,000

 

Note:

For computing the Indexed Cost of Acquisition for the FY 2016-17, the old CII has been adopted while the Indexed Cost of Acquisition for FY 2017-18 has been computed adopting the new CII notified vide Notification no. So 1790(e)[no. 44/2017 (f. No. 370142/11/2017-tpl)], dated 5-6-2017.

The above table gives us an idea on how the capital gains drastically varies from one scenario to another. However, as already discussed above, the taxpayer has the option to choose between the FMV or the Cost of Acquisition whichever would be more beneficial to him.

 

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