Updated on 15.06.2022
The word indexation is commonly used when we talk about capital gains tax on property, gold, or debt investments. In other words, indexation is the process used to calculate capital gains tax on appreciation earned by selling capital assets
other than Listed equity. Thus if a bond is invested in for its fixed
When you invest in some product for a defined and visible benefit then it’s not a capital asset, and thus will not generate any capital gains. Like if a bond or debenture is invested in for its fixed interest, then it’s not a capital asset, but when it is invested in to earn a profit by trading it in the Investments market than it is a capital asset.
Common capital assets include Equity shares/mutual funds, Tradeable debentures, bonds, Debt Mutual funds, Real estate, Gold. Whatever gain or loss comes out of selling these capital assets are termed as Capital gain/loss. The role of indexation comes in when there’s the long-term capital gain on capital assets other than equity.
What is indexation and how it helps in calculating Capital gains tax?
Basically, indexation is a process of adjustment of cost/purchase price of capital assets with Cost Inflation index. Through Indexation government allows the investor to adjust the effect of inflation on the Capital gains made on selling of property/asset purchased. In other
In other words, indexation helps in knowing that how much return has actually been eaten up by inflation and government reduces your Capital gains tax burden on that part. This way the gain earned gets reduced by the inflation adjustment which helps in tax saving. The effect of inflation is measured through cost
The effect of inflation is measured through cost inflation index number which is notified by the government for every financial year. There is an important change announced in budget 2017, where the Base period for calculating Indexed purchase cost has been changed from 1981 to 2001.
Confusing? Well, to understand all this you need to know about Cost Inflation Index first.
Cost Inflation Index is an Index notified by central government every year. This index is used to factor in the effect of inflation on capital assets. It used to start from FY 1981-82, which means that any property bought after 1981 has an index figure to calculated the inflation-adjusted cost to calculate capital gains tax. But if a property was bought before 1981, then the same needs to be valued based on the valuation report of the registered valuer, which would be termed as fair market value.
Now from FY 2017-18, the base year of cost inflation index has been changed to 2001. Means that if the capital asset was bought before 2001 then its valuation will be taken at fair market value to calculate capital gains tax.
New Cost Inflation Index as announced in FY 2017-18
Recently 2022-23 CII has been announced as 331.
Let’s understand Indexation with an example:
Ajay purchased a Residential house in Feb’2003 for Rs 10 lakh and sold the same house in Oct’ 2012 for Rs 40 lakh. What would be the taxable capital gain in this case?
Purchase date: Feb’03 (FY 2002-03) – CII is 105
Sale date: Oct’12 (FY 2012-13) – CII is 200
Total capital gain: Sale price – purchase price i.e. Rs 40 lakh- Rs 10 lakh = Rs 30 lakh
Taxable capital gain: Sale price – Indexed purchase price i.e. Rs 40 lakh – Rs 19.04 lakh = Rs 20.96 lakh
Indexed purchase price = Purchase price / CII for Purchase year*(CII for sale year)
=10 lakh / 105*(200) = 19.04 lakh
This way you can very well see that after indexation the taxable gain gets reduced by around 9 lakh. Thus the capital gains tax would be calculated on Rs 20.94 lakh rather than on Rs 30 lakh.
Some important points on capital gains tax related to indexation:
- Indexation applies only in the case of calculating Long-term capital gains tax and that too in non-equity or Non- equity related assets.
- The definition of long-term varies in different assets like in the case of debt products and gold (Physical or ETFs), the long term starts after the holding period of 3 years but in case of Real estate, the condition of holding period is reduced to 2 years from 3 years w.e.f Fy 2017-18
- The capital gains tax rate is 20% after indexation. It applies to all capital assets.
- In the case of property, you may not be required to pay capital gains tax @ 20%, as you have the option to buy capital gain bonds or another residential real estate.
Indexation is a very important concept to know as it helps in saving considerably on capital gains tax. This is because of indexation only, that debt mutual funds prove to be more tax-effective than traditional bank deposits.