Indexation refers to adjusting the impact of inflation on the value of an asset or transaction. In the context of income tax, it means recalculating the cost of an asset based on the prevailing inflation rates. The Cost Inflation Index (CII), issued annually by the central government in the official gazette, is used for this purpose. The indexed cost of acquisition is usually higher than the original purchase price, which helps lower the taxable capital gains.
This article covers the concept of indexation, how it is used in calculating capital gains with examples, and the advantages it provides.
Meaning of Indexation
In finance and economics, indexation helps determine the present value of a property or transaction by factoring in inflation. Inflation refers to the steady rise in the cost of goods and services. For instance, something worth ₹100 today might cost ₹110 next year, and even more in later years, thereby reducing purchasing power.
The Indian rupee has been subject to inflation for many years. Indexation allows past transactions to be adjusted to today’s price levels. In capital gains taxation, indexation is applied to the purchase price of a capital asset to compute the indexed cost of acquisition. Since present values are higher than past ones, this reduces the taxable capital gains.
The benefit of indexation is available only on long-term capital assets, such as land and buildings, and can be claimed by resident individuals and Hindu Undivided Families (HUFs), if they choose to apply it.
Applicability of Indexation Benefit
According to the Income Tax Act, the benefit of indexation applies only to long-term capital assets. Any asset held for more than 24 months qualifies as a long-term capital asset.
For transfers made after 23rd July 2024, indexation is available solely on long-term immovable property, such as land or buildings. This option can be exercised only by resident individuals and Hindu Undivided Families (HUFs).
For assets sold before 23rd July 2024, indexation benefits are allowed for all eligible long-term capital assets.
However, indexation cannot be claimed on the sale of listed equity shares, equity-oriented mutual funds, or units of business trusts. Similarly, for debt funds purchased on or after 1st April 2023, the gains are treated as short-term, making indexation inapplicable.
Capital Gains Calculation Using Indexation
Each year, the government publishes the Cost Inflation Index (CII). The indexed cost of acquisition is calculated by dividing the purchase price by the CII of the purchase year and multiplying it by the CII of the year of sale.
The advantage of indexation increases with longer holding periods. For instance, over a 5-year period, the effective tax rate on long-term capital gains can reduce from 20% to nearly 6–7%.
Example of Indexation Calculation
Suppose you bought a property in 2019 for ₹10,00,000. In 2024, you sell the same property for ₹25,00,000. At first glance, it looks like you made a capital gain of ₹15,00,000. However, due to inflation, the value of ₹10,00,000 in 2019 is not equal to the same amount in 2024. This is where indexation comes into play.
The Indexed Cost of Acquisition (ICoA) is calculated using the formula:
ICoA = Purchase Price × (CII of Sale Year ÷ CII of Purchase Year)
- Purchase Price = ₹10,00,000
- CII for FY 2024–25 = 363
- CII for FY 2019–20 = 289
ICoA = 10,00,000 × (363 ÷ 289) = ₹12,56,055
Now, the taxable capital gain will be:
₹25,00,000 – ₹12,56,055 = ₹12,43,945 (approx.)
With indexation, the taxable gain is lower, and at the long-term capital gains tax rate of 20%, the tax liability becomes ₹2,48,789 instead of being calculated on the full ₹15,00,000.
Benefits of Indexation
- Reduced Tax Liability – Indexation adjusts the purchase cost of an asset to account for inflation. Since the cost increases after indexation, the taxable capital gain decreases, leading to lower tax.
- Higher Post-Tax Returns – With reduced taxable gains, you retain a larger portion of your profits after tax, thereby improving your effective returns.
- Legally Accepted Tax Relief – Indexation is a legitimate tax-saving mechanism recognized under the Income Tax Act, helping taxpayers reduce their liability without using unfair means.
Related FAQs on Indexation
Q1. Can indexation be applied to all types of assets?
No, indexation benefit is available only on long-term capital assets such as immovable property (land and building). It is not available for listed shares, equity-oriented mutual funds, or business trust units.
Q2. Is indexation benefit available for NRIs?
Yes, NRIs can also claim indexation benefit on eligible long-term capital assets, provided the asset qualifies under the Income Tax rules.
Q3. How does indexation affect capital gains tax calculation?
Indexation increases the purchase cost of the asset, thereby reducing the taxable capital gains. This lowers the final tax liability on the sale of the asset.
Q4. Does indexation apply to debt mutual funds?
For debt funds purchased on or after 1st April 2023, gains are always treated as short-term and taxed as per slab rates, meaning indexation benefit is not applicable.
Q5. Why is indexation beneficial during high inflation periods?
The higher the inflation, the more significant the adjustment in the cost of acquisition, which substantially reduces capital gains tax payable.
