‘Indexation’ – It’s a term you might have heard of on our blog, or if you have ever sold a property or units in a debt mutual fund. As an investor it is one of those important terms that you should know about.
What is Indexation?
Indexation is a technique used to adjust the purchase price of certain types of investments for inflation. So if you bought something 10 years ago for Rs 100, with indexation its ‘purchase price’ could be double that or Rs 200 today.
Why should you know about indexation?
It comes in handy if you are planning to sell your old house for a new one or want to reduce your tax burden, especially if you invest in debt mutual funds.
Indexation helps to counter the erosion in the value of the asset over a period of time. Even the income tax department recognises that one needs to increase the purchase price of the asset so that it reflects inflation-adjusted true price in the year in which it is sold.
Before you try to understand Indexation, you have to understand Capital Gains.
Capital Gains is the difference in the selling price and Indexed purchase price for investments like real estate, mutual funds, bonds, gold, stocks, etc. These investments where your returns come from an increase in the value of the investment over time are usually referred to as capital assets. Fixed Deposits and other interest earning investments like NSC, KVP, etc. do not fall under this category.
So where does Indexation apply?
In general, indexation is applicable to long-term capital gains and not short term ones. So if a capital asset such as a house or a mutual fund unit is sold after 3 years, you can apply indexation to adjust the purchase price while computing capital gains.
(Please note that indexation is not applicable on long term capital gains for listed stocks and equity mutual funds)
How does indexation work – Two Examples
Indexation Benefit in Real Estate: A property purchased in the financial year 1995-96 for Rs. 20 lakhs was sold in the financial year 2011-2012 for Rs. 80 lakhs.
The Capital Gain is not 80-20= Rs. 60 lakhs. According to the Cost Inflation Index (see below), the 1995-96 index was 281 and that of 2011-12 was 785. So the indexed cost of the property in the year 2011-2012 would be = (20 X (785/281)) = Rs. 55.87 lakhs.
Hence, Long Term Capital Gains would be Rs. 80-55.87 = Rs. 24.13 lakhs. In indexation and capital gain terminology, the adjusted purchase price is called ‘indexed cost of acquisition’.
Indexation Benefit in Debt Mutual Funds: The same calculation is also true for Debt Mutual Funds to reduce tax burden after the completion of 3 years.
For example, you invest Rs. 1 lakh in a debt fund in January 2010 at a NAV of Rs. 10. And redeem all of it in July 2013 when the NAV is Rs. 15. The value of your investment is therefore Rs 1.5 Lakhs. However, since your investment is long term (more than 36 months) the entire gain of Rs. 50,000 will not be taxed for Long Term Capital.
With Indexation, your cost of acquisition will become Rs. 1 lakh X 939/632= Rs. 1.486 lakh. Thus the Long Term Capital Gain will be a meagre amount of Rs. 1,424. This will be taxed at 20% which is almost negligible.
(This tax treatment is what makes debt funds superior to bank FDs. Read more here)
Understanding Indexation Benefit and Long Term Capital Gains will help you choose the right investment because taxes are an important consideration while investing.
Important Note: The income tax act provides for specific conditions and also exceptions for the use of indexation. The above article is indicative and you must consult a tax advisor for determining your tax obligations.
Cost Inflation Index Values
As per Income Tax Act, Cost Inflation Index (CII) is a measure of inflation that is used for determining the indexed cost of acquisition. This is published every year for the financial year and is available on the website of the income tax department. The below table reproduces these values.