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Indexation is a way to adjust the value of an asset for inflation. It is done with the help of the Cost Inflation Index, which is released by the Central Government every year to adjust the effect inflation has on investments and the currency. By applying indexation, the burden of capital gains tax is reduced because the asset's value is adjusted for inflation, leading to lower capital gains (profits).
Key Takeaways
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Indexation means adjusting the original cost of an asset against inflation using Cost Inflation Index (CII).
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It generally applies to certain long-term assets, such as debt funds, held for the stipulated period and not to LTCG from equity investments, like equity shares or mutual funds.
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The asset value after indexation is known as the Indexed Cost of Acquisition (ICoA), determined by multiplying the purchase price by (CII of sale year / CII of purchase year).
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Indexation allows investors to maintain profitability on their investments even after paying taxes, since the tax liability is reduced.
Important Highlights
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From 1 April 2023, units of debt funds purchased are considered short-term capital assets and taxed at individual income tax slab rates; the indexation benefit is no longer applicable.
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For assets sold on or after 23 July 2024, long-term capital gains on listed equity shares, equity-oriented funds, and business trust units are taxed at 12.5% without indexation benefit.
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Individuals and HUFs selling immovable property acquired before 23 July 2024 can choose indexation with 20% tax or a flat rate of 12.5% without taxation.
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Although indexation adjusts acquisition cost for inflation and reduces tax burden, recent changes significantly restrict its applicability to the sale of immovable property, i.e. land or building or both.
Applicability of Indexation Benefit
Indexation benefit is applicable only for long-term capital gains (LTCG) arising out of the sale of immovable property. Though indexation was previously applicable to various long-term assets, after July 23, 2024, it is limited to immovable property sold by an individual or an HUF after that date. Units of business trusts, listed equity shares, and equity-oriented funds are no longer eligible for the indexation benefit. With effect from April 1, 2023, for debt funds, the units are considered as short-term investments and capital gains are deemed to be short-term capital gains (STCG), and therefore, the indexation benefit is not applicable.
You can calculate capital gains on immovable property with indexation to reduce your taxable income from the sale. For property acquired before July 23, 2024, Indian tax law offers individuals and Hindu Undivided Families (HUFs) the option to either use indexation with a 20% tax rate or a flat 12.5% tax rate without indexation. Indexation increases your acquisition cost by adjusting for inflation, which in turn reduces your overall taxable gain.
Understanding Capital Gain
Discussion on indexation revolves around capital gain, but how to measure it. Capital gain refers to the profit from selling any asset, either tangible or intangible.
Under the current tax regime, any investment with tenure of more than 36 months is considered a long-term investment. Conversely, an investment of 12 months duration or less, is called short-term investment. A fixed-rate of 20 percent tax is levied on long-term investments with indexation. On the other hand, investors need to pay according to their income tax slab on short-term capital gains.
How To Calculate Capital Gains With Indexation?
Indexation is an efficient way to prevent capital gains from being drained by taxes. As asset price appreciates, it brings less profit and hence, less tax. To calculate indexation, the rate of inflation is obtained from the Cost Inflation Index (CII), which the central government publishes on the income tax department’s website. However, the recent changes have limited the scope of applicability of indexation.
For long-term investment like immovable property, i.e., land or building or both, there are two options available to individuals and HUF:
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12.5% without indexation
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20% with indexation.
For all others, the capital gains tax rate is 12.5% without indexation.
Long-term capital gain tax for the sale of building, land, or both with indexation benefit, is calculated as explained below:
In case of immovable property, the indexed cost of acquisition is arrived at by using the Cost Inflation Index (CII), which is declared by the central Government every year.
Indexed cost of acquisition (ICoA) = Cost of acquisition x (CII of the year of transfer / CII of the year of acquisition)
Once you have the ICoA, you deduct this amount and the exemptions under section 54/54B/54D/54EC/54F from the sale value.
(Certain types of long-term capital gains may be eligible for exemptions under specific conditions, e.g., reinvestment in certain assets like residential property).
So, the formula to calculate the long-term capital gains chargeable is:
LTCG chargeable to tax = Net sale consideration - Indexed Cost of Acquisition - Cost of Improvement - Exemptions under Section 54/54B/54D/54EC/54F.
Let us consider an example.
An immovable property was purchased in September 2010 for Rs. 30,00,000/- and was sold in January 2025 for Rs. 1,00,00,000/-
CII index for FY 2010-11 was 167, and for FY 2024-25 it was 363.
Formula to calculate the indexed cost of acquisition
Indexed cost of acquisition = Cost of acquisition x (CII of the year of transfer / CII of the year of acquisition)
Indexed cost of acquisition in this example is - 30,00,000.00 X 363 / 167
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30,00,000.00 X 2.17365
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65,20,958.00
Full value of consideration 1,00,00,000.00
Less expenses incurred for this transfer 0.00
Net sale consideration 1,00,00,000.00
Less - indexed cost of acquisition 65,20,958.00
Less - Indexed cost of improvement 0.00
Long-term capital gain 34,79,042.00
Less: Exemptions under section 54/54B/54D/54EC/54F 0.00
Long-term capital gain chargeable to tax 34,79,042.00
Since the indexation benefit has been applied in the above example, the applicable capital gains tax will be 20%.
Computing Indexation on Equity and Equity MFs
In tax rate modification proposed in the budget of 2018-19 LTCG on equity shares is subject to a capital gain tax of 10 percent without indexation for any investment of more than one year.
To apply indexation on equity shares, investors need to calculate the actual cost of acquisition on it. It is calculated by arriving at the lowest of the asset and highest cost of the asset based on the fair market value of the underlying. Let’s elaborate with an example.
Equity is acquired on Jan 2017 at Rs 100. On January 31 in 2018, it’s fair market value is say Rs 200. Now, in May 2018 the equity is sold on the market for Rs 225. So, the cost of acquisition of CoA is Rs 25 (225-200).
Different scenarios can arise while calculating the actual cost of acquisition under different market scenarios. However, according to sub-clause (5) of clause 31 of the Finance Bill 2018, it is clarified that inflation indexation benefit wouldn’t apply in calculating CoA for long-term capital gains under the new tax regime.
However, investment upto Rs 1.5 lakh in certain notified equity-linked saving schemes is allowed under section 80/c. But, these are subject to lock-in of 3 years, where every SIP is calculated as a separate investment and holding period gets readjusted with each SIP date.
Advantages of Indexation
Indexation meaning, lowering your tax burden on long-term investments by adjusting against rising inflation. As the value of your investment appreciates, inflation in the economy also rises, meaning the purchasing power of the asset reduces. To adjust it according to the changing inflation rate nothing can beat the benefits of indexation. It is a boon for long-term investors to keep their investment from losing worth under changed purchasing power scenarios and at the same time lowering tax liabilities on it. Traditional investment tools like FD isn’t adjusted for inflation, and hence, you earn less on them despite staying invested for a longer period. Advantages of indexation make investing in debt funds and mutual funds lucrative for investors by allowing them to earn handsome profit post-tax deduction.
What is the Benefit of Indexation?
Indexation means lowering your tax burden on the gains from long-term investments in immovable property, i.e., land or building or both, by adjusting the value against the inflation rate. As the value of your investment appreciates, the net profit or gains you make reduce. This lowers your tax liability. Traditional investment tools like FD aren’t adjusted for inflation, and hence, you earn less on them despite staying invested for a longer period.
However, it important to remember that the Union Budget 2023 removed the benefit of indexation for debt funds purchased on or after April 1, 2023. In fact, tax changes have largely removed the benefit of indexation for other assets like debt fund investments, thereby impacting their post-tax profitability.