Use Indexation Benefits while computing Capital Gains Tax

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It's the time of the year when individuals would be filing their taxes. People are generally aware of various deductions that reduce the taxable income and hence decrease the tax payable. At the same time, extra income from rent and capital gains made on investments add to the taxable income and increase the tax outgo.

Deductions under section 80C of the income tax Act, including investments in Public Provident Fund, tax-saving fixed deposits, equity-linked saving schemes, life insurance, and others, are widely known. However, there seems to be lesser knowledge and clarity on the deductions that can be availed on the capital gains accrued by selling assets. Understanding this can significantly reduce tax liabilities and guide individuals on taking asset sale decisions prudently.

Indexation is one way that can help in reducing the tax liability of capital gains made by sale of certain assets. Indexation benefit can be availed when an applicable asset (fixed income mutual fund, real estate, unlisted shares and gold) is sold and long term capital gain (LTCG) applies. LTCG is applicable on real estate if it is sold after 2 years of purchase, while it's applicable after 3 years for fixed income mutual fund, gold and unlisted shares.

Indexation means adjusting the price of an asset for inflation. The price of various assets increase over time and this inflation is captured by a broad indicator called Cost Inflation Index (CII). CII is declared for every financial year by the Central Board of Direct Taxes and is used to calculate the indexation benefit on asset sale. Say, we invested Rs1 lakh in a mutual fund in April 2014 and now, after 3 years, the value of our investment is Rs1.4 lakh. Then Rs40,000 is our capital gain.

Inflation and real gain

Say, the price of an asset in 2014 was Rs1 lakh and over 3 years the price has increased to Rs1.15 lakh. This increase in price over time is inflation. 

Further, let's assume that in April 2014, we invested Rs1 lakh to buy this item in future. Now, in 2017, we wish to buy that item but the price has gone up to Rs1.15 lakh. the same time, our investment has grown to Rs1.4 lakh. So what is the real gain in this case?

After purchasing our item for Rs1.15 lakh today in 2017, we are only left with Rs25,000. So the real gain that we have made is Rs25,000 only, and not Rs40,000. In this example, Rs15,000 is the impact of inflation, which is the difference between mathematical gain and real gain.

CII helps us estimate the real gain in various scenarios. Using the CII numbers of the particular years, we can calculate the real gains (adjusted for inflation) for our case. CII data shows that an item worth '240' in FY2014-15 is available for '272' today (FY 2017-18). In that case, an item worth Rs1 lakh in FY2014-15 would be available for 100,000 * 272/240 = Rs113,156. This is also known as CII-adjusted purchase price.

Therefore, our real gain is only Rs 26,844.

Indexation benefit on capital gains with cost inflation index

In the above example, since the investment is being sold after 3 years, LTCG applies and we shall get the indexation benefit.As calculated above, the CII adjusted purchase price of the investment is Rs113,156. As per the income tax rule on debt mutual funds, the investor needs to pay 20% tax on the gains after index adjustment, which is equal to Rs26,844. Hence, the tax outgo (LTCG at 20% after indexation as per I-T rules) = 20 * 26,844 = Rs5,369.

In the above example, if we would have sold the debt fund within 2 years, the gains would have been treated under short term capital gains (STCG) and our tax outgo would have been (assuming 30% tax slab) = 30 * 40,000 = Rs12,000.

If you notice, we have to pay the tax only on the real gains and the tax rate is 20%. The tax saved by virtue of indexation on LTCG is Rs6,631, as compared to STCG.

While filing taxes, individuals should check the assets that they have sold during the financial year and avail the indexation benefit, if applicable. 

It can also be used in planning the asset sale. If your debt fund investments are near to completing 3 years since purchase and you are thinking of selling them, it might be worthwhile to wait for some more time and avail the indexation benefit on LTCG.

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