Inflation erodes the value of money over time. What costs ₹100 today might cost ₹110 next year. Indexation is a method that adjusts the original purchase price of an investment to account for this increase in prices. By using indexation, you don’t get taxed on the part of your profit that simply keeps up with inflation—you pay tax only on your real gains.

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How Indexation Works

Governments publish a Cost Inflation Index (CII) each financial year. This index measures how much prices have risen. To use indexation, you take the purchase price of your asset and multiply it by the ratio of the CII of the year you sell the asset to the CII of the year you bought it. The result is the indexed cost of acquisition, which is higher than your original purchase price. This higher cost reduces your taxable capital gain.

Indexation in Mutual Funds

Different types of mutual funds have different tax rules:

Debt mutual funds: Indexation benefits apply when you hold the investment for at least 36 months. If you sell before three years, the gains are treated as short‑term and are added to your income for tax purposes. For holdings of three years or more, indexation lets you inflate your purchase cost and pay lower tax on the gain.
Equity mutual funds: Indexation does not apply to equity‑oriented funds. Long‑term gains on equity funds (held for over 12 months) are taxed at a flat rate, while short‑term gains are taxed based on your income slab.
Recent rule changes: For debt funds purchased after 1 April 2023, the government treats all gains as short‑term, meaning indexation cannot be used. Additionally, new rules from July 2024 restrict indexation benefits mainly to long‑term sales of immovable property (land or buildings) for resident individuals and Hindu Undivided Families (HUFs).

Calculating Indexation: Step by Step

To calculate the indexed cost of your mutual fund units or other capital assets, follow these steps:

Find the CII for the purchase year and the CII for the sale year. These figures are published annually by the Income Tax Department.
Apply the formula:
Indexed Cost of Acquisition = Original Purchase Cost × (CII in Year of Sale ÷ CII in Year of Purchase)
Compute your taxable gain: Subtract the indexed cost from the sale value. This result is your long‑term capital gain.
Apply the tax rate: Long‑term capital gains on debt funds are usually taxed at 20 % plus applicable cess, but the indexed cost reduces the taxable portion.

Example:

Suppose you bought 5,000 units of a debt mutual fund at ₹18 each in 2013 (CII = 200) and sold them in 2019 at ₹27 each (CII = 280). Without indexation, your gain per unit is ₹9. With indexation:

Indexed purchase price per unit = 18 × (280 ÷ 200) = ₹25.20
Taxable gain per unit = 27 − 25.20 = ₹1.80
Total taxable gain = 5,000 × ₹1.80 = ₹9,000

Indexation reduces your taxable profit from ₹45,000 to ₹9,000, leading to significant tax savings.

Tax Rules and Eligibility

Long‑term vs. short‑term: Assets held for more than 24 months (immovable property) or 36 months (debt funds) are long‑term; shorter holding periods make them short‑term.
Exclusions: Indexation cannot be applied to listed equity shares, equity mutual funds or units of business trusts.
Timing matters: To claim indexation, the sale must occur before certain cutoff dates (such as 23 July 2024 for general assets) unless the asset is immovable property owned by a resident individual or HUF.

Benefits of Indexation

Lower tax liability: By raising the purchase price to account for inflation, your taxable gain decreases, resulting in a smaller tax bill.
Higher post‑tax returns: Paying less tax means you keep more of your investment gains.
Fairness: Indexation ensures you are taxed on real profits, not inflationary increases.
Legal and accepted: Indexation is a government‑approved method; it reduces taxes without any questionable strategies.

Conclusion

Indexation is a powerful tool that adjusts the purchase cost of long‑term investments for inflation, ensuring you pay tax only on real gains. It’s particularly useful for debt mutual funds and long‑term property holdings, helping investors reduce tax and enhance post‑tax returns. By understanding how indexation works and staying updated on tax rules, you can make smarter decisions and keep more of your hard‑earned money.

Frequently Asked Questions (FAQs)

Is indexation only for mutual funds?

No. Indexation applies to many long‑term capital assets, including real estate. However, current rules restrict the benefit to certain asset types and holding periods.

Does indexation apply to equity mutual funds?

No. Long‑term gains on equity funds are taxed at a flat rate without indexation.

Can I use indexation if I hold a debt fund for less than three years?

No. The investment must be held for at least 36 months to qualify for indexation.

What happens if I buy a debt fund after April 2023?

Gains on debt funds purchased on or after 1 April 2023 are treated as short‑term and are added to your income for tax purposes, so indexation doesn’t apply.

Where do I find the Cost Inflation Index?

The Ministry of Finance publishes the CII for each financial year. You can find it on the Income Tax Department’s website or in budget documents.

Does indexation guarantee lower tax every time?

Indexation usually reduces tax, but the benefit depends on inflation and the length of time you hold the asset. If inflation is low or the holding period is short, the effect may be minimal.

Can non‑residents claim indexation benefits?

The rules mainly apply to resident individuals and HUFs. Non‑resident taxation can differ, so it’s best to consult a tax professional.

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