How Indexation Helps You Save Tax

Article originally published in Gujarati Mid-day newspaper on June 08, 2021. Here is the transcript of the same.

Knowing about indexation benefits is very important for investors as it will help to save tax. But, before, understanding indexation we must understand inflation. Inflation is the gradual increase in prices of products or services over a period of time. For eg., Something that was available for Rs. 90 yesterday, is available today for Rs. 100 and may cost Rs. 110 in the next month. Alternatively, we can say that the same Rs. 100 will be insufficient to procure that thing after a month i.e. the value of Rs. 100 eroded over the period.

If we see over the period of the last 40 years, inflation has remained in the range of 6 to 7%. Something which was available for Rs. 6,300 in 1980 costs approximately Rs. 1 lakh in 2021. Thus, inflation reduces your purchasing power over time.

Now, let's understand Indexation. For eg., You bought a house 10 years ago in March 2011 for Rs 25 lakhs and sold it in March 2021 for Rs 60 lakhs. Your Gain on sale of the house in Rs. 35 lakhs. However, you may think that considering the inflation has risen so much and prices of houses have gone up due to inflation also, it would be unfair if you have to pay tax on Rs. 35 lakhs. The government thus provides relief in form of allowing you to index (increase) the purchase price of the house with respect to inflation. A higher purchase price means lesser profits, which effectively means a lower tax.

Indexation benefit is available for long term capital assets. Every year government issues the figures of the Cost Inflation Index (CII) which is available on the Income Tax Department’s website. Indexation refers to the adjustment of the purchase price of an asset to account for inflation between the time you bought and sold it.

Indexed cost is arrived as "Cost of Asset ÷ CII in the year of purchase × CII in the year of sale". In our example, the cost of a house is Rs. 25 lakhs. The CII in the year of purchase is 167 and in the year of sale is 301. Now, if we add indexation benefit, the indexed cost of the house is Rs. 45 lakhs (25 lakhs ÷ 167 × 301) and you pay tax on Rs. 15 lakhs (60-45) and not on Rs 35 lakhs.

You can actively use indexation benefit to earn more from your investments too. Let's understand with another example. Suppose in March 2016 Ram invested Rs 10 lakhs in Fixed Deposit for 5 years @7%. Shyam invested Rs 10 lakhs in Debt Mutual funds. Coincidentally, Shayam,’s mutual fund also generated a return of 7% CAGR in 5 years period ending March 2021. Both Ram and Shyam received a redemption amount of Rs 14,02,552. Hence, both earned a pre-tax income of Rs 4,02,552. Assuming that both are in the income tax slab of 30%, ideally, both should pay tax Rs. 1,25,596 which is a Redemption amount of Rs. 14,02,552 – Investment of Rs. 10,00,000 taxed at 30% plus cess.

Since Shyam invested in Debt Mutual Funds, he gets the double benefit. Firstly, Long Term Capital Gains are taxed at @20% and secondly, he gets the benefit of indexation. A holding period of 36 months or more is considered as long term for Debt Funds. Shyam ends up paying only Rs. 54,518 as tax which is Redemption amount 14,02,552 less indexed cost of investment which is 11,85,039 (10 lakhs ÷ 254 × 301). Hence capital gain for purpose of income tax is Rs 2,17,513 taxed at 20% plus cess which is Rs. 45,242. Shyam by applying appropriate knowledge of income tax and putting to effective use the indexation benefit saved tax of Rs. 80,354.

The above indexation benefit is available on various long term capital assets such as Gold, Debt Mutual Funds, House Property, etc.

Question

I have purchased a house in May 2019. Can I get indexation benefit if I sell the house now? How much tax do I need to pay?

Answer

Generally, long term capital assets are any capital assets held by the taxpayer for a period of more than 36 months immediately preceding the date of its transfer. However, for house property, this rule has provided special consideration and any house property held for 24 months or more is considered as long term capital asset. Accordingly, you have to pay tax @20% after availing indexation benefit.