How you can take the benefit of indexation

With the deadline for filing tax returns approaching, two friends, share their tax woes.

Ram: I made a neat gain of ₹1 lakh when I sold some of my old mutual funds (MF). But what the market giveth, the taxman taketh. I wonder what will be left after the taxman’s cut.

Shyam: Worry not. Let’s see if you can apply indexation.

Ram: What is indexation and what has it got to do with my taxes?

Shyam: Well, indexation is one of the few acts of kindness from the tax department. So, accept it graciously when you can! Under the Income-tax Act, you can apply indexation, that is, adjust the purchase price of an asset for inflation while calculating capital gains.

Ram: As if taxes were not enough, you want me to deal with inflation too!

Shyam: No. You see, this is one time, you wish inflation were higher! To calculate capital gains, you must deduct the purchase price of an asset from its sale price. But you also need to account for the erosion in the value of that asset over time due to inflation. So, the tax laws allow you to adjust your purchase price for inflation before you calculate your capital gain.

Ram: So, I can finally put the soaring Consumer Price Index inflation to some use.

Shyam: Not so fast. You can only use the Cost Inflation Index (CII), published by the Indian Income Tax Department for indexation. Let me give you an example. If you invested ₹2 lakh in debt MF schemes and redeemed your investments at ₹3 lakh a few years later, then your capital gain isn’t really ₹1 lakh.

Ram: Then what is it?

Shyam: If the CII for the year of purchase is 100 and for the year of sale, 120, then you can adjust your purchase cost by a multiple of 1.2 (120 / 100). That is, your inflation- adjusted purchase cost is ₹2.4 lakh (and not ₹ 2 lakh) and your capital gain effectively becomes ₹60,000 (₹3 lakh minus ₹2.4 lakh). It’s on this amount, that you pay 20 per cent tax.

Ram: Let me use indexation to get whatever I can out of my MF investments.

Shyam: It’s not that simple. You can seek refuge in indexation for investments made in debt MF schemes, but not equity schemes. Also, you can do this only for long-term capital gains, that is, only if you held on to your debt MF investments for 36 months or longer.

Ram: Should have known that ‘terms and conditions apply’ always!

Shyam: Don’t be disappointed. You can also use indexation for other assets such as property (land/ house) and gold (jewellery / ETF). Gains made on sale of property held for more than two years and gold held for more than 3 years are considered ‘long-term’.

Ram: Maybe I shouldn’t crib when my wife buys and sells gold. As long as she does it after three years!