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Indexation in India: Tax benefits and Budget 2024 changes

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Published Date: 11 Sep 2024Updated Date: 27 Dec 20246 mins readBy MOFSL

Introduction

As an investor, there are many aspects that can fall under a concerning radar for you. One such significant factor is taxation. You want to maximise your tax liabilities to ensure your investment returns are not eroded by high tax bills. Various tools and strategies are available to achieve this.

Among them is a particular method called indexation that offers taxation benefits while accounting for economic factors. In this blog, we deep dive into understanding how indexation works and how it can benefit you.

What is indexation?

Indexation is a mechanism applied to long-term investments like debt funds, real estate, bonds, and other asset classes. It is a method of adjusting the purchase price of an asset to reflect inflation over time. Due to such adjustment, the impact of inflation is reduced, so is the tax liability.

For example, when an asset is sold, the profit made is subject to the capital gains tax. However, with indexation, the original price of an asset is adjusted against inflation using the government-published Cost Inflation Index (CII). It helps accurately define the capital gains. As a result, the taxes are levied on the actual gains that surpass inflation. With such fairer taxation, you avoid overpaying and save on taxes.

Indexation and capital gains: How does it work

The CII plays an integral role in putting the indexation into effect. It is a measure of inflation that the government releases every financial year. It reflects the increase in price over time and is used to adjust the purchase price of an asset, and thereby its capital gains.

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Suppose you invested in a debt fund with an amount of Rs. 10,000 in 2019. You bought individual units of this share at a Net Asset Value (NAV) of Rs. 10. Three years later, you have earned capital gains on the asset and can redeem it at Rs. 20 on Nov, 2022. Your investment incurred a capital gains of Rs. 20,000 on an initial investment of Rs. 10,000.

However, you will incur tax on your investment. Since your investment period was three years, you can apply indexation to reduce the value of long-term capital gains and forego any excessive tax.

To understand how tax benefit works, you can calculate the Indexed cost of Acquisition using the formula:

ICoA = Original cost of acquisition x (CII of the year of sale/ CII of the year of purchase)

In this case, the ICoA = 10,000 x (Rs. 289 released for 2019/Rs. 264 released for 2022)

As a result, the ICoA is Rs. 10,947. The adjusted capital gains = 20,000 – 10,947 = Rs. 9,053.

Hence, the tax of 20% is calculated on Rs. 9,053, which amounts to Rs. 1,810. 

Indexation advantages for investors

The many indexation benefits in taxation are as follows:

·        Tax efficiency

As there is lower tax liability due to the reduced taxable capital gains, you become more efficiently capable of managing your taxable income.

·        Protection against inflation

Tax-savings and indexation are interlinked as the inflation is taken into consideration. Without indexation, the entire gain gets taxed. But as it account for inflation, the real value of your investment is protected.

·        Long-term investment

Indexation benefits are primarily applicable to assets held over a long period. Hence, it encourages long-term investments, which are great to counter the market forces and achieve stable capital growth.

·        Wide applicability

Indexation is not limited to one type of investment. It is applicable to a wide variety of long-term capital assets like real estate, debt mutual funds, gold bonds, etc.

·        Simplified tax planning

With indexation, you are in a better position to plan your taxes. It makes you aware of CII and how it impacts your capital gains, which lets you accurately forecast your tax liabilities.

Budget 2024: Update on indexation

The government, while passing the budget on 23rd July, 2024 has discontinued the indexation benefit. Hence, you can no longer adjust the purchase price of your assets to account for inflation. This directly impacts the taxation on capital gains. Long-term capital gains on Debt Funds are now taxable at 12.5% without the indexation. The holding period for it is also reduced from 36 months to 24 months. As for real estate assets, you can calculate taxes at 12.5% without indexation or 20% after indexation. The choice is available if you have purchased them before 23rd July, 2024.

Conclusion

Indexation benefit on capital gains significantly influences your tax planning. While recent changes in Budget 2024, may affect how indexation is applied, it still helps to understand how this mechanism works for investments like real estate assets where you can still apply indexation based on the date of purchase. You can now make informed decisions and optimise your investment returns by way of adjusting the capital gains as per inflation. Thereby, reducing tax liability.

 

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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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