The Buyt Desk
Indexation refers to the process of adjusting the cost of acquisition of an asset over a specific duration to bring it to the present-day prices after considering inflation. Indexation enables investors to predict the total gain or losses incurred on the investments.This eventually alleviates the complete tax liability by adjusting the purchase price of the underlying investment or asset with the inflation level. Moreover, it also provides the ability to understand the higher gains after adjusting the inflation rate of the purchase and sale year.
In this post, understand how you can benefit from using this concept for your long-term investments, and how to calculate it.
What is indexation?
In layman’s terms, indexation is the process that enables an investor to adjust the purchase price of an asset based on the inflation rate in the economy. Increasing the purchasing price becomes easier by considering the inflation between the purchase and sell time (year). Eventually, it will help you in avoiding decreasing ROI (return on investments) and pay tax after the inflation adjustment. Since the purchase price is indexed, it will provide lower gain which finally results in lower tax liability. Under the indexation concept, the term price index is used for purchase price indexing.
Benefits of indexation
Investors can avail of numerous benefits through indexations –
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Indexation helps in increasing or decreasing the value of an investment according to the current inflation level in the market or economy.
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Increasing the purchase price or acquisition cost of an asset or an investment through indexation considering inflation means lesser profits or lower long-term capital gains (LTCG), thereby reducing the tax burden of an investor.
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By providing indexation benefits to investors, indexation promotes long-term investment.
How does indexation reduce the tax burden of investors?
Inflation and capital gains both are different concepts. As now you understand the meaning of indexation, let’s learn about capital gains. It refers to a rise in the price or value of an investment over a certain period. In simpler terms, the profit you gain from selling your assets like jewelry, real estate etc. is taxed as capital gains. The purchase price adjustment for inflation is referred to as indexation. This helps in decreasing the tax burden.
Let us assume that you buy apples at the cost of INR 100 per Kg (kilogram). You buy 1 kg and then store them. After one month, the cost of the same apples increases up to INR 110 per Kg. Now, you sell those stored apples at the rate of INR 120 per Kg. So, you get a profit of INR 20 from the transaction.
Profit from sale = SP (selling price) – CP (cost price),
Profit from sale = 120-100 = 20.
Since the purchase price in the market is INR 110 now, the government enables you to purchase price adjustments to show the increase in the cost due to inflation. Thus, taxation gain from the sale will be 120 (selling price) -110 (cost of apples in the current market) = 10. The reduction in taxable gains reduces your tax liability.
Remember one thing indexation will help in reducing the tax burden only when the assets are sold after holding them for a particular number of years. This may depend on the type of asset or investment you hold. The benefit of indexation can be availed after 2 years for selling the immovable property.
How to calculate indexation?
You can calculate the indexation using the following formula –
Indexation = original cost of purchase x CII (cost inflation index) of the specific year/CII of the base year.
Here, the CII of the specific year is the CII of the sale year and the CII of the base year is the CII of the purchase year.
The first step to calculating an inflation-adjusted purchase price is to find the purchase price including the transaction charges. Then, find the CII of the year of purchase and sale year. Use the above formula to get the correct indexed cost of purchase. You can get the CII number from the website of the income tax department. Here, you can get the cost inflation index from the year 1981 onwards.
