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# How cost inflation impacts your capital gains tax

When it comes to calculation of capital gains tax, an important concept to understand is indexation of capital gains. Let us understand the concept of indexation first!  Assume that you bought a property in May 2008 at Rs.75 lakhs. After 10 years you sell your property in May 2018 at Rs.1.75 crore. However, you are appalled to read that you will have to pay 20% tax on your profits. You make a quick mental calculation and your heart sinks when you realize that you will end up paying a whopping Rs.20 lakhs (20% of Rs.1 crore profit) as tax to the government of India. That is when your financial advisor asks you not to worry since there is the benefit of indexation available to you, which will reduce the tax that you have to pay on your profits on sale of property. First the annual index numbers..

FY2001-02FY2002-03FY2003-04FY2004-05FY2005-06FY2006-07100105109113117122FY2007-08FY2008-09FY2009-10FY2010-11FY2011-12FY2012-13129137148167184200FY2013-14FY2014-15FY2015-16FY2016-17FY2017-18FY2018-19220240254264272280
What is this concept of cost inflation and how it impacts capital gains?
We all face inflation on a daily basis. Due to the impact of inflation, the value of the rupee goes down. The Rs.75 lakhs that you paid in 2008 will be worth a lot more today. Obviously, asking you to pay tax on the difference is actually unfair to you. That is where Income Tax offers you the benefit of cost inflation indexing. The Income Tax Department announces the relevant index number for every financial year (as captured in the table above). You can use this cost inflation index number to calculate your revised capital gains. What you effectively do is to inflate the cost of your purchase to the present day using the cost inflation index numbers and recalculate the capital gains. You have to pay tax only on the indexed capital gains which is calculated after considering the indexation factor.

Cost Inflation Index - LTCG versus STCG
When it comes to all non-equity asset classes, the definition of long term for capital gains purpose is 3 years. Only for equities, it is 1 year. In the case of sale of property if you have held the property for more than 3 years then it will be treated as LTCG. Otherwise, it will be treated as STCG. In case of STCG your tax rate will be your peak tax rate (20% or 30% as the case may be). That is the rate that is applied to short term gains. There is no benefit of indexation available in case of STCG. However, the benefit of cost inflation indexation will be available in case of LTCG. Let us now understand Capital Gains index calculation and the impact of cost inflation index on capital gains tax. Let us also see with a practical example how cost inflation index affects capital gains tax India.

Working out your LTCG tax with indexed cost inflation index
Let us understand the application of cost inflation indexing by extending our above example of property sale after 10 years. Consider the table below..

TransactionAmountCapital Gains CalculationAmountDate of Purchase15th May 2008Gross Capital GainsRs.92,00,000Property CostRs.75,00,000Index Value 2008-09137Registration & stampingRs.5,00,000Index Value 2018-19280Acquisition CostRs.80,00,000Index Factor â€“ (280/137)2.0438Date of Sale18th May 2018Indexed Cost of Buy (B)Rs.1,63,50,400Sale PriceRs.1,75,00,000Indexed LTCG (A â€“ B)Rs.8,49,600Legal and statutory costsRs.3,00,000Tax at 20%Rs.1,69,920Effective Sale Price (A)Rs.1,72,00,000

Capital GainsRs.92,00,000Effective tax paid1.85%

The impact of changing inflation on purchasing power can be calculated using an inflation calculator. Use the Motilal Oswal Inflation Calculator in India to estimate the future cost. As can be seen from the above calculation of LTCG, the indexation proffers a huge benefit when you sell any asset. By using the indexation benefit, the investor is able to reduce the impact of capital gains tax from 20% to just 1.85%. That is how indexing helps to enhance your post-tax returns. The benefit of indexation applies to all asset classes as long as the gains are classified as LTCG.

There is one exception to this rule
While the benefit of indexation is available for all long term capital gains, the exception is equities and equity funds. Till the fiscal year 2017-18, long term capital gains on equities were tax free in the hands of the investors. However, effective fiscal year 2018-19 all long term capital gains on equities will be taxed at 10% above a profit threshold of Rs.1 lakhs per annum. However, this will be a flat tax and the benefit of indexation will not be allowable in this case.

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