Indexation plays a crucial role in calculating gain or loss on your investments. Indexation lowers your overall tax liability by adjusting the purchase price of the underlying asset or investment.

The article covers the following aspects of indexation:

1. What Is Indexation?

Are you worried about inflation eating away into your returns? Does the income tax law consider inflation while calculating capital gains on the sale of investments?

Stop worrying, start indexation!

Indexation is a prudent way to prevent draining of your returns on investments by way of taxes. Indexation applies to long term Investments which include debt fund and other asset classes. Indexation helps you to adjust the purchase price of the investments. In this way, you will be able to lower your tax liability.

Before embarking on indexation, it is vital that you understand two other concepts – inflation and capital gains.

Inflation is the gradual increase in the price of a product or service. For example, what is worth Rs.100 today may be worth Rs.110 or more next year; and even more than that the year after. In this way, inflation adversely affects 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 go from Rs.100 to Rs.110 because of inflation, but its value will remain the same.

2. 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 time frame. If the NAV of your debt fund was Rs 10 last year and today it stands at Rs 15, the value of your investment has appreciated. You would experience a capital gain of Rs. 5 per unit in case of a sale of the investment.

In other words, a capital gain is a difference between the purchase price and the sale price of an investment. In the case of debt funds which are long term in nature(held for more than 36 months), capital gains are arrived after indexing the purchase price of the investment.

Unlike equity funds, long term capital gains on debt funds are taxable at the rate of 20% with the benefit of indexation. Remember, indexation does not apply to equity funds.

3. 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 a lesser profit, which effectively means a lower tax.

Though indexation, you will be able to lower your long-term capital gains, bringing 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 used for indexation can be taken 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.

4. How does Indexation work in Debt Funds?

Gains from the sale of debt mutual fund units are classified as capital gains, which allows the investor to use indexation while computing the tax. This is applicable to long-term capital gains on investments that have been held for 36 months and more.

Let’s say you invested in a debt fund in July 2016. Your investment amount was Rs.10,000, and you bought the units at a NAV of Rs.10. Three years later, you redeem your investments in August 2019 at a NAV of Rs.20.

Hence, when you sold your investments, the value of your investments was Rs.20,000. Your investment made capital gains worth Rs.10,000. However, you need not pay tax on this entire amount of Rs.10,000.

As your holding period was 3 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)

In the example mentioned above, the indexed cost of acquisition will be 10,947, i.e., (10,000 * 289/264). Hence, instead of Rs.10,000, your capital gains will now be Rs.9,053, i.e. (Rs.20,000 – Rs.10,947).

Using indexation, you would have managed not to pay tax on Rs.947 of your gains. Your tax will be computed on only Rs.9,053, which will be equal to Rs.1,810.

The benefit of indexation works best when your holding period is longer. For a holding period of 5 years, long-term capital gains tax on debt funds 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.