scorecardresearchBenefits of indexation: How it helps you save tax?

Benefits of indexation: How it helps you save tax?

Updated: 17 Sep 2022, 02:00 PM IST
TL;DR.
Indexation enables the tax payer to account for how inflation will affect acquisition costs. In essence, this reduces the amount of capital gains that would be subject to tax. Let us discuss more about it.
Indexation enables the tax payer to account for how inflation will affect acquisition costs.

Indexation enables the tax payer to account for how inflation will affect acquisition costs.

All of us are aware with the concept of inflation and its effects. In comparison to what you can buy today, you will be able to buy less products for the same amount of money year after year. Because of inflation, the price of a good or service will go up or we can say that your purchasing power will reduce.

Now, your estates and properties may also experience this. Let's say you purchased a home in 2012 for 20 lakhs, and as of today, the selling price is 70 lakhs.

The gains from the sale of assets, including immovable property/real estate, jewelry, bonds, and non-equity mutual funds, among many others, are subject to capital gains tax. And because of this, you could have to pay a significant tax sum if you plan to sell your house.

In such a situation, the concept of indexation might help you.

What is indexation?

Indexation is a useful strategy for avoiding the taxation of your investment profits. Applicable to long-term assets like real estate and debt funds, it aids in adjusting the asset's acquisition cost for inflation. Indexation enables the tax payer to account for how inflation will affect acquisition costs. In essence, this reduces the amount of capital gains that would be subject to tax. When indexation advantage is present, the cost of the purchase rises sharply, reducing your tax liability and boosting your savings.

It is important to keep in mind that this benefit is only accessible if the assets are sold after being held for a specific period of time, which might vary based on the type of asset you own. If immovable property is sold after a two-year term, the advantage of indexation may be obtained.

How to calculated indexed cost?

Cost Inflation Index (CII) is a statistic used to estimate the annual rise in the cost of products owing to inflation.

Indexed Cost = {Purchase price* CII (Sale Year)}/CII(Purchase Year)

Let’s go back to example we discussed in the beginning. The cost of house in 2012 was 20 lakhs. And let us say that CII was 100 in 2012 and now when you plan to sell it, in 2022, the CII is 317.

 Purchase priceSelling priceProfitsTax
Before Indexation20,00,00070,00,00050,00,00010,00,000
After Indexation63,40,00070,00,0006,60,0001,32,000

From the above table, you can deduce how indexation helps you save a huge amount in tax.

The purchase price of an investment is modified through indexation to account for the impact of inflation on it. Lower earnings result from a greater purchasing price, which in turn results in a lower tax.

Your long-term capital gains can be reduced with the use of indexation, which lowers your taxable income. When compared to traditional fixed deposits, indexation makes debt funds an outstanding fixed-income investing choice. Hence we can easily say that indexation turns investing into a win-win situation.

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First Published: 17 Sep 2022, 02:00 PM IST