The profit that you make on selling a long-term capital asset is called a long-term capital gain. But as you know, inflation erodes the value of money. For instance, the value of Rs 100 was worth more 10 yrs ago than what it is today. That is why when computing the gains on selling a capital asset, it is important to adjust the purchase price to account for inflation.
This is done by way of indexation, a method used to reduce tax liability on selling a capital gain. Indexation accounts for inflation from the year of purchase of an asset to the year of sale.
How does indexation work?
- It inflates the purchase price of an asset by accounting for inflation until the year of the sale
- It reduces the capital gains you earn on selling an asset
- Finally, it brings down your tax on capital gains
Before looking at an example, let us understand what are capital assets and capital gains.
Capital asset: This is an asset that you hold for over a year with an intention to not to resell but derive benefits from it for a longer period of time. These can be financial securities, real estate, and so on in the form of short- or long-term assets. But for the purpose of indexation, we shall focus on long-term capital assets—held for 12 to 36 months depending on the asset class.
Capital gain: The profit you earn on selling a capital asset after you have held it for a minimum holding period is called a capital gain. So when you sell a residential property after holding it for at least 3 yrs, the profit you make thereon is a long-term capital gain. Simply put, a capital gain is a difference between the sale price and the purchase price of a capital asset. As with any other taxable income, long-term capital gain also attracts income tax.
For instance, if you had bought a residential property for Rs 10 lakh in Mar 2003 and sold it for Rs 35 lakh in Mar 2020, then you have earned a capital gain of Rs 25 lakh. Here, the property is a long-term capital asset and the profit is long-term capital gain, which attracts income tax. Assuming the rate of tax on long-term capital gains is 10%, your tax liability on the sale of the property would be Rs 2,50,000! But thanks to indexation, you don’t have to pay tax on Rs 25 lakh. Here’s why.
As mentioned, indexation inflates the purchase price of an asset. Keeping the sale price of the asset constant, a lower purchase price increases your capital gain and tax liability. On the contrary, a higher purchase price decreases long-term capital gain and tax thereon. For this purpose, you ascertain the indexed cost of acquisition. Meaning adjusting Rs 10 lakh for inflation over 17 yrs of holding period so it reflects today’s value.
The rate of inflation considered here is derived from the government’s Cost Inflation Index (CII), available on the income tax department’s website. Once you have the CII data, you can calculate the indexed cost of acquisition of the asset or its inflation-adjusted value as follows:
Indexed cost of acquisition = Original cost of acquisition x (CII of the year of the sale/CII of year of purchase)
In our example, the indexed cost of acquisition of the residential property = Rs 10 lakh x (280/105) = Rs 26,66,667
Effectively, the capital gains will now be Rs 8,33,333 (Rs 35,00,000 minus Rs 26,66,667) as against Rs 25 lakh before indexation. Naturally, your tax on capital gain also reduces to Rs 83,333 as against Rs 2,50,000 before indexation.
By now you may have understood the benefit of indexation. It helps reduce your long-term capital gains and, in turn, brings down your overall taxable liability.