What is cost inflation index and indexation? To understand indexation, let us quickly see what we mean by capital gains. If you sell an asset such as real estate, stocks, mutual funds, jewellery etc, you earn a profit from such a transaction. This profit is called capital gain. If you sell an asset after 36 months from date of purchase, the profit you make is called long term capital gain. If you sell an asset within a year of its sale, the profit you make is called short term capital gain. There are exceptions to these definitions but then this is an article on indexation!
However, like a nagging housewife who does not want to let go of her husband's wallet, the government does not want to let go of its share in our monetary happiness – it wants us to share our capital gain in the form of capital gain tax which it levies. So, the tax you pay on your capital gains is called capital gains tax. Let us see the formula for capital gains (not capital gain tax).
Capital Gains = Full Value of Sale – Indexed Cost of Acquisition – Indexed Cost of Improvement – Any exemptions
Indexed Cost of Acquisition = Cost of acquisition * Cost Inflation Index (CII)
Full value of sale is the actual cost at which the asset is sold. Note the word "indexed" in the formula above. Note the formula for indexed cost of acquisition. For this article let us forget Indexed Cost of Improvement and exemptions so that it becomes easy for us to understand indexation.
The cost of acquisition is nothing but the cost of purchase. Let us see what CII is.
Why Indexation?
The idea is that inflation reduces the asset value over a period of time and so the government is kind enough to allow us to jack up the purchase price of the asset and reduce the profit and hence the tax that we have to pay to it.
Indexation helps us to counter the erosion in the value of the asset over a period of time. Using the inflation index, 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.
Tax liability on capital gain with indexation and without indexation
In case of long term capital gains, the tax liability is the lower of the amount arrived at by the two methods below:
# 20% tax liabilities arrived at by indexation method
# 10% tax liabilities arrived at by without using indexation method
In the example above, using indexation, the tax liability comes to (20/100) * 5,07,712 = Rs 101,542
If you were to not use indexation,
Capital gains = sale price of asset – cost of acquisition = 35,00,000 – 20,00,000 = Rs 15,00,000
Capital gains tax on this at 10% = (10/100) * 15,00,000 = Rs 1,50,000
This is around 48% of what you would pay when you were to use indexation. So obviously, using indexation is better as you benefit in saving taxes.
So to recap:
- Indexation means incorporating the impact of inflation during the holding period of the capital asset by adjusting its purchase price so that the actual value of the asset is at par with the current market prices.
- The government publishes the inflation index factor each year.
- Indexation helps us to lower our capital gains tax.
- Indexation can be applied on improvements done to the house as well.
- Indexation calculations are different for properties passed on by inheritance.
