What is indexation benefit?

Income Tax Income from Capital Gains
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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 FYs for your reference!

Cost Inflation Index table
Cost Inflation Index table1253×321 23.4 KB

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.

Tax liability with and without indexation
Tax liability with and without indexation941×281 22.5 KB

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!

1 Like
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My sister had constructed a house in 2003 which has been inherited by me now after her death. I wish to sell this house now. But, no bills or documents are available for cost of its construction. I would like to know how to assess its construction cost for calculation of capital gain after its sale.

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Hey @J.R_Mehta,

You can take the FMV(Fair Market Value) as per the year when the property was acquired as the cost of acquisition.

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Thanks for your reply. Could you please elaborate how can I determine the FMV of the house at the time of its acquisition? Shall I have to get it determined by a certified valuer?

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Hey @J.R_Mehta,

You can get the FMV from a registered valuer for that date. Further, once you get the cost of acquisition, you can calculate the indexed cost and pay taxes on the capital gains.

Hope this helps!

6

Thanks a lot for your valuable advice.

1 Like
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I had invested Rs.5000/- on:16.02.2005 in Mutual Fund & sold it on 08.09.2023 for Rs.59824/- .The FMV & COA of the invested amt .as on 31.01.2018 was Rs.29209/- .Can I avail the indexation opportunity to calculate the profit out of these transactions ? If so,what will be the amount of my profit ?,

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Hey @sandichu,

In case of equity mutual funds, LTCG were made taxable from 2018 onwards. Hence, in this case, you can consider the FMV as of January 31, 2018 as the cost of acquisition and calculate your capital gains.

Moreover, long-term capital gains from equity shares/mutual funds are taxed at 10% without indexation benefit. But, you do get an exemption of ₹1 lakh. Hence, if your long-term gains are not exceeding ₹1 lakh, there will be no tax liability on these gains.

Hope this clarifies.

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Indexation benefit is a tax-saving method used in certain countries, including India, to adjust the cost of an asset for inflation when calculating capital gains tax.

Here’s how it works: When an individual or entity sells an asset such as real estate, stocks, or mutual funds, they usually have to pay capital gains tax on the profit made from the sale. However, instead of taxing the entire profit amount, indexation allows the investor to adjust the purchase price of the asset for inflation, thereby reducing the taxable portion of the gain.

The indexation benefit takes into account the increase in the cost of living over time, as measured by an inflation index, such as the Consumer Price Index (CPI). By applying this indexation factor to the original purchase price of the asset, the taxable capital gains are effectively reduced, resulting in lower tax liability for the investor.

Indexation benefit helps ensure that investors are not unfairly penalized by paying taxes on gains that are merely a result of inflation, rather than real increases in the value of the asset. It provides a more accurate reflection of the actual gains earned by the investor after accounting for the erosion of purchasing power due to inflation.