Indexation: Meaning, Benefits, Calculation and More

Indexation in general means adjusting the effect of inflation on the value of a property or a transaction. In income tax, indexation refers to arriving at the cost of the asset according to current inflation rates of the currency. Cost Inflation Index is released every year by the central government in the official gazette. Indexed cost of acquisition is always greater than the actual cost of acquisition, thereby reducing the overall capital gains implication. 

This article explains in detail, the meaning of indexation, capital gains calculation using indexation benefit with examples, and benefits of indexation. 

Meaning of Indexation 

• Indexation is generally used in finance and economics to arrive at the current value of a transaction or a property, by adjusting the inflation effect on the transaction. Inflation is the gradual rise in the price of a product or service.

 For example, what is worth Rs.100 today may be worth Rs.110 or more in the following year; and even more than that the year after. In this way, inflation reduces your purchasing power.

• Indian rupee is on an inflationary trajectory since long period. Indexation is a method to arrive at the value at the current inflation rates, for the transactions that happened in the past.
• In capital gains taxation, indexation is applied to the purchase cost of a capital asset, to arrive at indexed cost of acquisition. Since the value at current price level is always higher than the past level, the capital gains taxation can be reduced using indexation benefit.
• Indexation benefit can be applied only on the long term capital assets, namely immovable property (land and buildings), by a resident individual and HUF, at their choice.  

Applicability of Indexation Benefit

• As per the provisions of the Income Tax Act, Indexation benefit is applicable only for long term capital asset.
• Any capital asset held for more than 24 months is considered as long term capital asset.
• For sales after 23rd July 2024,  - indexation benefit is available only for long term capita assets being immovable property (land or building). This option is available only for resident individuals and HUF.
• Indexation benefit can be claimed for capital assets sold before 23rd July 2024. 
• At any case, no indexation benefit can be claimed on sale of listed equity shares, equity oriented funds and units of business trust.
• For debt funds purchased on or after 1st April 2023, the capital gains are always considered as short term, hence no indexation applicable.

Capital Gains Calculation using Indexation Benefit

• As already discussed, the cost Inflation Index is released every year by the central government. The purchase cost is divided by the inflation index of the purchase year and multiplied by the inflation index of the sale year to arrive at the indexed cost of acquisition.
• The benefit of indexation works best when your holding period is longer. For a holding period of 5 years, long-term capital gains tax can come down from 20% to 6-7%.

Indexed Cost of Acquisition = Purchase cost of Capital Asset * Cost Inflation Index of sale year / Cost Inflation Index of the purchase year

Let understand the calculation of indexation with an example:

Illustration

• Let’s say you purchased a property in 2019 for Rs. 10 lakhs. In 2024, you decided to sell the property at the current market price of Rs. 25 lakhs. So, you have a capital gain of Rs. 15 lakhs. 
• Now the value of Rs. 10 lakhs in 2024 is not the same as it was in 2019. Hence, indexation!
• To arrive at the Indexed Cost of Acquisition (ICoA), you have to use the formula mentioned above:
  • Purchase cost = Rs. 10 lakhs
  • Cost Inflation Index of 2024-25 = 363
  •  Cost Inflation Index of 2019-20 = 289 
  • ICoA = Rs. 10 lakhs * (363/289) = Rs. 12,56,055
• Hence, instead of Rs.15 lakhs, your capital gains will now be Rs. 12,43,944 i.e. (Rs.25,00,000 – Rs.12,56,055).
• On choosing indexation benefit, the capital gains are taxed at 20%, which will be equal to Rs. 2,48,788. 

What are the Benefits of Indexation?

• Reduced taxes: Indexation is used to adjust the purchase price of an investment to reflect the effect of inflation on it. A higher purchase price means lesser profits, which effectively means a lower tax.
• Higher post tax returns: Since indexation reduces capital gains, the profits after taxation remaining in your hands will be more.
• Legal tax saving tool: This tax saving method is accepted method under the income tax act, resulting in lesser taxes without any fraudulent tactics.