Indexation: Meaning, Benefits, Calculation and More

Indexation plays an important role in calculating gain or loss on your investments. Indexation will reduce your overall tax liability by adjusting the purchase price of the underlying asset or investment. You will be able to realise higher gains as you can adjust them against the rate of inflation of the year of purchase and sale.

Read this article to know everything about indexation!

What Is Indexation?

Are you worried about inflation reducing your returns? Does the income tax law consider inflation while calculating capital gains on the sale of investments? Stop worrying, start indexing!

Indexation is an efficient way of preventing draining of your returns on investments in the form of taxes. Indexation is applicable to long-term investments in the form of house property and land. Indexation helps you in adjusting the purchase price of the investments by considering inflation. In this way, you will be able to lower your tax liability. Before thinking about indexation, you must understand two other concepts – inflation and capital gains.

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.

It means for the same amount of money; you will be able to buy fewer things year after year as compared to what you can buy today. The cost of a product or service will increase because of inflation.

How are Capital Gains calculated with Indexation on Mutual Funds

Now, let’s take a look at capital gains.

Capital gains refer to an increase in the value of an investment over a specific timeframe. If a property was purchased for Rs. 10 lakhs in 2003 and today it stands at Rs.75 lakhs, the value of your investment has appreciated, and this is called capital gains. Here, your investment would yield a capital gain of Rs. 65 lakhs on redemption.

In other words, a capital gain is a difference between the purchase price and the sale price of an investment. In the case of land, which are long-term in nature (held for more than 24 months), capital gains are arrived after indexing the purchase price of the investment. 
Unlike equity funds, long-term capital gains on property is taxable at the rate of 20% with the benefit of indexation or 12.5% without indexation, whichever is beneficial to the taxpayer. Remember, indexation does not apply to equity funds. 

What are the Benefits of Indexation?

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.

With the help of indexation, you will be able to lower your long-term capital gains, which brings down your taxable income. Indexation is the reason why debt funds are considered an excellent fixed-income investment option when compared to conventional fixed deposits (FDs). Indexation makes the game of investment a win-win affair.

The rate of inflation to used for indexation can be obtained from the government’s Cost Inflation Index (CII). The Central Government determines the values in the index and is updated on the income tax department’s website. You can view the Cost Inflation Index from 1981 onwards.

How does Indexation work?

Let’s say you purchased a property in 2019 for Rs. 10 lakhs. In 2022, 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 2022 is not the same as it was in 2019. Hence, indexation!

However, you need not pay tax on this entire amount of Rs.65 lakhs. As your holding period was three years, you will get the benefit of indexation to reduce the value of your long-term capital gains. To arrive at the Indexed Cost of Acquisition (ICoA), you have to use the following formula:

ICoA = Original cost of acquisition * (CII of the year of sale/CII of year of purchase)

The indexed cost of acquisition will be Rs.10,94,696, i.e., (10,00,000 * 289/264). 
Hence, instead of Rs.15 lakhs, your capital gains will now be Rs. 14,05,304 i.e. (Rs.25,00,000 – Rs.10,94,696).

Your tax will be computed at the rate of 20% on only Rs. 14,05,304, which will be equal to Rs. 2,81,061.

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%. This is how indexation helps you to save tax on long-term capital gains from debt mutual funds and enhance your earnings.

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Cost inflation index