What is indexation benefit and how can it help you save taxes?

While calculating your capital gains, very often, you must have come across the term “indexation”. Let’s understand what it actually means and how it can help you save taxes.

To understand indexation, consider this:

You purchased a jewellery piece for ₹20,000 and sold it three years later for ₹30,000 to one of your friends. As the difference between the purchase price and selling price is considered as capital gains, here, your capital gains of ₹10,000 (₹30,000 - ₹20,000) would be taxable.

However, with rising inflation, the price of the same jewellery would have also gone up, say to ₹24,000.

So, if we account for inflation, we can adjust the purchase cost of the jewellery to ₹24,000 which would now lead to lower capital gains of ₹6,000 (₹30,000 - ₹24,000).

This adjusted purchase cost is known as ‘indexed cost’ and the reduction in taxable gains is what we refer to as the ‘indexation benefit’.

What is indexation?

Going by the definition, indexation is a method of adjusting the purchase price of an asset based on the prevailing inflation rate. Over time, as the purchasing power of money reduces, indexation helps you determine your capital gains, taking inflation into account.

How do you calculate indexation?

The purchase cost of the asset is adjusted based on inflation and this rate is determined by using the CII, which is the cost inflation index. This metric is released by the government every year.

Here’s the cost of inflation chart for the past 10 FYs for your reference!

The formula used to derive the indexed cost of an asset is as follows:

Indexed cost = Actual purchase price x (CII for the year of sale/CII for the year of purchase)

We can take an example.

Suppose, you sold a property in December 2023 for ₹80 lakhs, which was originally purchased in May 2015 for ₹40 lakhs.

So to calculate the indexed cost of purchase, we use the formula,

Actual purchase price x (CII for 2023-24/CII for 2015-16)

= 40L * (348/254)

= 54.80L

This means that after adjusting inflation rates, your purchase cost of the asset would be 54.80L.

Hence, your capital gains will be the difference between the indexed cost of purchase and the sale price, which will be ₹25.20L (₹80L - ₹54.80L).

These long-term gains will be taxed at a rate of 20%, and hence you would effectively save ₹2.96 lakhs in taxes due to the indexation benefit.

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Indexation benefit is available on the following assets:

  • Securities (both listed and unlisted)
  • Immovable property being land, building or both
  • Physical gold and digital gold
  • Hybrid mutual funds with equity exposure between 35% to 65%
  • Other assets like jewellery, paintings, sculptures, etc.

Remember, that the indexation benefit applies only in case of long-term capital gains.

Have questions? Ask 'em below!

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