When it comes to the buying power of money, inflation is a tyrant. Inflation occurs when the costs of goods and services rise, diminishing money’s buying power. What Rs 100 can buy you now will not buy you anything in five or ten years. Even within a year, prices may grow, and the Rs 100 may not be enough to pay the same expenditures.
In terms of your investments, inflation diminishes their actual value, lowering the value of the returns you obtain from them. When computing your tax due on such returns, the Income Tax Department provides you with some leeway in the form of indexation advantage. Let’s have a look at what indexation is all about.
What exactly is Indexation?
Indexation is a strategy of lowering your long-term capital gains tax burden. The purchase price of the asset is increased in accordance to the inflationary trend in the economy under indexation benefit to estimate the inflated purchase price when the asset is sold after a few years. The capital gains are then calculated by subtracting the selling price from the inflated buying price. This profit is then subject to taxation.
The inflated purchase price is calculated using the CII – Cost Inflation Index – data produced by the Central Board of Direct Taxes (CBDT) and published by the RBI.
Here’s an illustration of the impact indexation has on your taxable capital gains: Assume you paid Rs 5 lakh for an asset in 2015. You sell it for Rs 8 lakh in 2021. The increased buying price would be estimated using the indexation approach. Assume that the indexed purchase price is Rs 6 lakh. Using this inflated purchase price, capital gains tax would be assessed on just Rs 2 lakh (Rs 8 lakh – Rs 6 lakh = Rs 2 lakh), rather than the Rs 3 lakh that would normally apply.
The Advantages of Indexation
The following are the most notable indexation advantages:
- Taxable capital gain reduction: Indexation raises the acquisition price, cutting the taxable capital gains from assets.
- Reduced tax liability: As the value of your taxable profits decreases, so does your tax responsibility.
- Increased disposable income: As your tax burden decreases, you have more assets in your hands to invest in appropriate avenues to develop a significant corpus for your financial goals.
Where you can get the indexation benefit?
Long-term capital gains from many types of assets are eligible for indexation benefits. Debt mutual funds, real estate, gold, and unlisted shares are just a few examples. If you make a long-term capital gain through one of these methods, you can utilise the indexation advantage to increase the purchase price and minimise the capital gain that would be taxed.
It should be noted that this rise in purchase price and fall in capital gains is solely on paper and only for the purpose of calculating tax liabilities. It has no bearing on the real transactions you’ve done or will make.