When it comes to calculating gains or losses on your investments, indexation plays a crucial role. By adjusting the purchase price of an asset or investment for inflation, indexation can significantly reduce your tax liability, allowing you to realize higher gains. In this article, we explore the concept of indexation, its benefits, and how it is calculated.
Budget 2024 Update
As of July 23, 2024, the government has discontinued the indexation benefit on long-term capital gains. This change means investors can no longer adjust the purchase price of their investments for inflation when calculating capital gains for tax purposes. Consequently, long-term capital gains will now be computed based on the actual purchase price, potentially leading to higher taxable gains and, therefore, a higher tax burden.
What Is Indexation?
Are you concerned about inflation eating into your investment returns? Does the income tax law account for inflation when calculating capital gains on the sale of investments? Enter indexation—a method that ensures your returns aren't eroded by taxes due to inflation.
Indexation is an effective way to safeguard your investment returns from the impact of inflation. It is primarily applicable to long-term investments, such as debt funds and other asset classes. By adjusting the purchase price of your investments, indexation helps lower your tax liability. To fully grasp indexation, it's essential first to understand the concepts of inflation and capital gains.
Inflation refers to the gradual increase in the price of goods and services over time. For instance, something worth Rs.100 today might cost Rs.110 or more next year, reducing your purchasing power. Essentially, the same amount of money will buy fewer goods and services in the future due to inflation.
How Are Capital Gains Calculated with Indexation on Mutual Funds?
Capital gains represent the increase in the value of an investment over time. For example, if the Net Asset Value (NAV) of a debt fund was Rs.10 last year and has risen to Rs.15 this year, the value of your investment has appreciated, resulting in a capital gain. In this case, your investment would yield a capital gain of Rs.5 per unit upon redemption.
Capital gains are essentially the difference between the purchase price and the sale price of an investment. For long-term investments like debt funds (held for more than 36 months), capital gains are calculated after applying indexation to the purchase price.
Unlike equity funds, long-term capital gains on debt funds are taxed at 20%, with the benefit of indexation. It's important to note that indexation does not apply to equity funds.
What Are the Benefits of Indexation?
Indexation adjusts the purchase price of an investment to account for inflation. A higher purchase price means lower profits, which translates to a lower tax liability.
Through indexation, you can effectively reduce your long-term capital gains, thereby lowering your taxable income. This benefit is one of the reasons why debt funds are often considered a superior fixed-income investment option compared to traditional fixed deposits (FDs). Indexation can make investing a win-win scenario.
The rate of inflation used for indexation is derived from the government’s Cost Inflation Index (CII), which is periodically updated by the Central Government and available on the Income Tax Department’s website. The Cost Inflation Index is available from 1981 onwards.
How Does Indexation Work in Debt Funds?
Let’s say you invested Rs.10,000 in a debt fund in July 2016, purchasing units at a NAV of Rs.10. Three years later, in August 2019, you redeem your investments at a NAV of Rs.20. The value of your investment at the time of sale would be Rs.20,000, resulting in capital gains of Rs.10,000.
However, you don’t need to pay tax on the entire Rs.10,000. Since your holding period was three years, you qualify for the benefit of indexation, which reduces the value of your long-term capital gains. The Indexed Cost of Acquisition (ICoA) is calculated using the following formula:
In this example, the indexed cost of acquisition would be Rs.10,947 (Rs.10,000 * 289/264). Therefore, instead of paying tax on Rs.10,000, your taxable capital gain would now be Rs.9,053 (Rs.20,000 – Rs.10,947).
Using indexation, you would effectively avoid paying tax on Rs.947 of your gains, and your tax liability would be calculated on Rs.9,053, amounting to Rs.1,810. The benefit of indexation increases with a longer holding period. For instance, with a 5-year holding period, the effective long-term capital gains tax on debt funds could decrease from 20% to as low as 6-7%. This is how indexation helps you save on taxes for long-term capital gains from debt mutual funds and enhances your overall returns.
Indexation remains a valuable tool for investors looking to maximize their returns by minimizing their tax liabilities. However, with recent changes to the tax laws, it's essential to stay informed and consider the implications on your investment strategy.
