What is Indexation?
When determining capital gains related to non-equity mutual funds, property, gold, and other investments where you are taxed on long-term capital gains (LTCG), the application of indexation benefits helps calculate the net capital gain. Many of us would agree that inflation significantly diminishes the income earned from such capital assets. To comprehend inflation, let’s consider a straightforward example. Suppose a carton of sweets was priced at Rs. 100 last year, it would now cost around Rs. 110 due to inflation, which represents the decline in the purchasing power of money. Considering India’s high inflation rate, estimated at 6.5%, investing in a debt fund can be risky. After three years of investment, a significant portion of the long-term capital gains may have been eroded by inflation.
Let’s assume you invested Rs. 200,000 in a debt fund, and after three years, you received Rs. 280,000, resulting in a long-term capital gain of Rs. 80,000. However, considering the impact of inflation during the same period, the purchasing power decreased by Rs. 25,600. Consequently, it doesn’t make sense to pay long-term capital gains tax on the entire Rs. 80,000, does it?
Indexation provides a straightforward method to determine the real value of an asset sale by accounting for inflation. By utilising the Cost Inflation Index (CII) from the income tax website, you can easily calculate this value. Let me explain this with an example of a purchase and sale of a debt mutual fund.
Purchase value: Rs. 200,000
Year of purchase: 2008
Sale value: Rs. 500,000
Year of sale: 2018
Long-term capital gain: Rs. 300,000
Without indexation, you would have to pay tax at a rate of 20% on the capital gains of Rs. 300,000, which amounts to Rs. 60,000. However, we can reduce the LTCG by considering indexation. To calculate the indexed purchase value, we need to refer to the Cost Inflation Index (CII) table provided by the income tax department.
In our example, the CII for the year of purchase (2008) is 137, and the CII for the year of sale (2018) is 280. Therefore, the indexed purchase value can be calculated as follows:
Indexed purchase value = Purchase value * (CII for the year of sale / CII for the year of purchase)
= Rs. 200,000 * (280 / 137)
= Rs. 407,299.27
Long-term capital gain = Sale value – Indexed purchase value
Therefore, in our example:
LTCG = Rs. 500,000 – Rs. 407,299.27
= Rs. 92,700.73
Consequently, the tax would be 20% of Rs. 92,700.73, amounting to Rs. 18,540.15, which is significantly lower than the Rs. 60,000 you would have paid without considering the indexation benefit.
As mentioned earlier, you can calculate the indexed purchase value for taxable long-term capital gains on assets such as debt funds, real estate, gold, etc., using the above method. The income tax department’s Cost Inflation Index utility can assist you in determining the indexed purchase value of your capital assets without the need for manual calculations.
It’s important to note that non-equity-oriented or debt funds generally yield returns of approximately 8% to 10%, which is roughly equivalent to the Indian inflation rate over the past several years.