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07 Apr 2020

What is Indexation

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As you look to start investing in mutual funds, or have already invested in mutual funds, you may come across the term ‘indexation’. In this article, we’ll look at what indexation is, why it matters and why you should be doing it!

What is Indexation?

In essence, indexation adjusts prices for inflation, taking a price in the past and updating it to current prices via inflation. Indexation is a method of adjusting purchase prices of investments for inflation. For example, if you bought a house for Rs. 50 lakhs 5 years ago, what would its purchase price be today, accounting for inflation - indexation is the method to determine that.
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Why indexation is important

Indexation is important as it is an extremely crucial tool for investors who can use it to reduce their tax burden and thus, pay fewer taxes.
If you bought a house, and are looking to sell it (or have sold it) this year, or if you have invest in debt mutual funds, indexation will reduce your taxes for the year.

Let’s go back to the house example. What you are doing is increasing the purchase price of the house to today’s Rupee value. Since the purchase price is now higher, the difference between the purchase price and your selling price is now less. So you will pay less tax, as the profit you are reporting is less. This doesn’t take away from the actual CASH that you receive, it is an accounting method the government recognizes.

What is Capital Gains

Indexation applies to your capital gains. But what is capital gains? Capital gains are the income you make from selling an investment - it is the difference between the purchase price and the selling price. Capital gains apply to real estate, mutual funds, bonds, gold, stocks, etc. A capital gain is an increase in the capital asset that you have invested in - a capital asset is an investment that is expected to increase in value over time e.g. a house.

How does indexation work?

You can apply indexation to capital gains, reducing your gains and therefore, reducing your tax liability. But remember - indexation can only be used for long-term capital gains and not short term capital gains. If you sell a house after 3 years, long-term capital gains applies (and so does indexation). If you sell it before 3 years, short-term capital gains applies (and no indexation)

Note - indexation is does NOT apply to long term capital gains for listed stocks and equity mutual funds).

Let’s look at an example of how indexation works.

Real Estate: You buy a house in 2000 for Rs. 1 crore. You then sell it in 2010 for Rs. 2 crores. So the capital gains is Rs. 1 crore? Wrong! You now will index the original purchase price for inflation.

Using the table below, the Cost Inflation Index in 2000 was 406 . In 2010 it was 711. The formula for indexation is:
Original Purchase Price x (Selling Year CFI/Purchase Year CFI) = Indexed Purchase Price
Applying to our house, this would be:
1 crore Original Purchase Price x (711 Selling Year CFI/ 406 Purchase Year CFI) = 1.7 crore Indexed Purchase Price

Your long term capital gains would be:
Selling Price - Indexed Purchase Price = Capital Gains
2 crore - 1.7 crore = Rs. 30 lakhs

You would now need to pay tax on Rs. 30 lakhs, instead of Rs. 1 crore!

You cannot use indexation for equity mutual funds, but you can use them for debt mutual funds that you have long-term capital gains on (ie. selling after 3 years). Use the same method and formula to calculate your indexed cost of acquisition.

For example, you invest Rs. 10,000 in a debt fund in 2005 at a NAV of Rs. 10. Five years later, you redeem it in 2010 when the NAV is Rs. 15. Since you sold after 3 years, you are eligible for long term capital gains. So what are your indexed gains?

Your indexed cost of acquisition is:
Rs. 10,000 Original Purchase Price x (711 Selling Year CFI/ 497 Purchase Year CFI) = Rs. 14,300 Indexed Purchase Price

Your long term capital gains would be:
Selling Price - Indexed Purchase Price = Capital Gains
15,000 - 14,300 = Rs. 700

Since long term capital gains on mutual funds are taxed at 20% in India, your tax will be on Rs. 700.

Important Note: The above article is for informational purposes only. Please speak with a tax advisor for accurate tax for yourself.

Cost Inflation Index

Here is the Cost Inflation Index provided by the Indian Income Tax Department:


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This publication is provided for general information purposes only and is not intended to cover every aspect of the topics with which it deals. It is not intended be advice. You must obtain professional advice before taking, or refraining from, any action on the basis of the content in this publication. The information in this publication does not constitute legal, tax, investment or other professional advice from North Loop or its affiliates. We make no representations, warranties or guarantees, whether express or implied, that the content in the publication is accurate, complete or up to date. All opinions expressed do not reflect the views of North Loop nor are endorsed by North Loop.