What is Indexation & how it works? | All about indexation benefit

Summary

This video by Aastha Khurana from Zerodha Varsity Videos explains the concept of indexation benefits on long-term capital gains. It illustrates how inflation affects asset value and how indexation adjusts the buying price to reduce tax burden. The video covers the benefits of indexation, asset classes eligible for it, and the formula for calculating index cost using the Cost Inflation Index (CII). It also provides a practical example of calculating indexation benefits on a property, highlighting the tax savings possible due to this adjustment.

Takeaways

• 😀 Indexation is a benefit that adjusts the cost of an asset for inflation over time, reducing the tax burden on long-term capital gains.
• 📈 The process of indexation involves adjusting the original cost of an asset using the Cost Inflation Index (CII), which reflects the inflation of a given year.
• 💡 CII is a government-determined number that increases with inflation, and it is used to calculate the index cost of an asset.
• 🏠 Assets such as real estate, physical gold, jewelry, certain government securities, and debt funds with specific equity exposure qualify for indexation benefits.
• 📊 The formula for calculating index cost is the original cost multiplied by the CII of the year of sale, divided by the CII of the year of purchase.
• 💼 Capital gains tax is calculated by subtracting the index cost from the selling price, not the original buying price.
• 🔑 The indexation benefit is only applicable to long-term capital gains, which typically means holding the asset for more than two years.
• 📉 The benefit of indexation helps in reducing the tax liability by considering the increased value of assets due to inflation.
• 💰 Investors are motivated for long-term investing as they can avail the indexation benefit on their long-term capital gains.
• ⚠️ Before April 1st, 2023, debt funds had the benefit of indexation, but this is no longer applicable for investments made after this date.
• 📝 For mutual funds, the indexation benefit is calculated based on the purchase and sale dates of the units, especially for those invested before April 1st, 2023.

Q & A

What is indexation?

Indexation is the process of adjusting the purchase price of an asset for inflation to reduce capital gains tax.

How does indexation benefit investors?

Indexation reduces the tax burden on investors by accounting for inflation, thus lowering the taxable capital gains.

Which asset classes are eligible for indexation benefits?

Eligible asset classes include real estate, physical gold, government securities, and certain debt funds with equity exposure between 35% to 50%.

What is the Cost Inflation Index (CII)?

The CII is a number set by the government that reflects inflation for a specific year, used to calculate indexation.

How is the indexed cost calculated?

The indexed cost is calculated by multiplying the original cost by the CII of the sale year and dividing by the CII of the purchase year.

Why was the benefit of indexation removed for debt funds after April 1st, 2023?

The government changed the tax rules, removing indexation benefits for new investments in debt funds to simplify taxation.

How does indexation affect long-term capital gains?

Indexation lowers long-term capital gains by adjusting the asset's cost for inflation, thus reducing the taxable amount.

What is an example of calculating indexation?

If a property was bought for ₹9 lakhs in 2007 and sold for ₹1.05 crores in 2023, the indexed cost is calculated using the CII values, reducing the taxable gain.

Why is indexation important for long-term investors?

It incentivizes long-term investing by reducing tax liabilities through adjustments for inflation, making long-term investments more attractive.

What happens if an asset is sold without using indexation?

The entire capital gain is taxed without any adjustment for inflation, leading to a higher tax liability.

Outlines

00:00

📈 Understanding Indexation Benefits

This paragraph introduces the concept of indexation benefits on long-term capital gains. Aastha Khurana, from Zerodha Varsity Videos, uses the analogy of a limited edition watch to explain indexation. The watch's value increases from ₹50,000 to ₹60,000 due to inflation, and the capital gain is calculated by adjusting the buying price with inflation, resulting in a reduced tax burden. The benefits of indexation include inflation adjustment of asset values, reduced tax burden, and encouragement for long-term investment. The paragraph also lists asset classes eligible for indexation benefits, such as real estate, physical gold, and certain financial instruments.

05:01

📉 Changes in Indexation for Debt Funds

The second paragraph discusses the changes in the indexation benefits for debt funds. It clarifies that while indexation benefits are no longer available for new investments in debt funds post-April 1st, existing investments made before this date continue to enjoy these benefits. The summary also explains the process of calculating indexation benefits for mutual funds based on the purchase and sale dates of units. The paragraph concludes by emphasizing the importance of understanding the impact of indexation on tax liabilities and investment strategies, especially in light of recent changes in regulations.

Keywords

💡Indexation Benefit

Indexation Benefit refers to the adjustment of the cost of an asset for inflation over the period of its holding. It is a method used to calculate capital gains tax by considering the effect of inflation on the original cost of the asset. In the video, the concept is introduced through a story about a limited edition watch, where the original cost of ₹50,000 is adjusted to ₹55,000 due to inflation, thus reducing the capital gain and the tax liability when the watch is sold for ₹60,000.

💡Capital Gains Tax

Capital Gains Tax is the tax levied on the profit made from the sale of a capital asset, such as stocks, real estate, or other investments. In the context of the video, it is explained that capital gain is calculated by subtracting the buying price from the selling price. However, with indexation, the buying price is adjusted for inflation, which can reduce the taxable capital gain, as demonstrated with the watch example.

💡Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. The video script uses the example of a watch's price increasing from ₹50,000 to ₹55,000 due to inflation, which is a key factor in calculating the indexation benefit.

💡Index Cost

Index Cost is the adjusted cost of an asset that takes into account the effect of inflation. It is used to calculate the capital gain when an asset is sold after holding it for a long period. In the video, the index cost is calculated by multiplying the original cost by the Cost Inflation Index (CII) of the year of sale and dividing it by the CII of the year of purchase.

💡Cost Inflation Index (CII)

Cost Inflation Index (CII) is a numerical value determined by the government to reflect the inflation rate of a particular year. It is used in the indexation process to adjust the cost of assets for inflation. The video explains that the CII for the year of sale and the year of purchase are used to calculate the index cost of an asset.

💡Long-Term Capital Gains

Long-Term Capital Gains refer to the profits made from the sale of a capital asset that has been held for more than the specified holding period, which is typically more than one year. The video emphasizes that indexation benefits are available on long-term capital gains, which encourages investors to hold assets for longer periods.

💡Asset Classes

Asset Classes are categories of investments, such as real estate, stocks, bonds, and commodities. The video script mentions several asset classes where indexation benefits can be availed, including real estate, physical gold or jewelry, SGBs before maturity, G-Secs bought from RBI direct, and debt funds with certain equity exposure.

💡Debt Funds

Debt Funds are a type of mutual fund that invests in fixed-income securities like bonds, government securities, and corporate debt. The video explains that indexation benefits were available for certain debt funds before April 1st, 2023, but are no longer applicable for investments made after that date.

💡Mutual Funds

Mutual Funds are investment vehicles that pool money from many investors to invest in a diversified portfolio of stocks, bonds, or other securities. The video mentions that the indexation benefit for mutual funds is calculated based on the purchase and sale dates of the units, and that the benefit is available for investments made before April 1st, 2023.

💡Tax Burden

Tax Burden refers to the total amount of tax paid by an individual or a business. The video script explains that by adjusting the cost of assets for inflation through indexation, the tax burden on investors is reduced, as the capital gain is calculated on the adjusted cost rather than the original cost.

💡Investing

Investing is the act of allocating resources, usually money, with the expectation of generating an income or profit. The video script uses the concept of indexation to illustrate how long-term investing can be advantageous due to the benefits of reduced tax liability on capital gains.

Highlights

Indexation benefits on long-term capital gains explained.

Introduction to indexation by Aastha Khurana from Zerodha Varsity Videos.

A simple story illustrates the concept of indexation with a limited edition watch.

Capital gain calculation formula: selling price minus buying price.

Adjusting for inflation to calculate capital gains tax.

Indexation adjusts the buying price due to inflation, known as index cost.

Benefits of indexation include asset value adjustment, reduced tax burden, and motivation for long-term investing.

Asset classes eligible for indexation benefits include real estate, physical gold, and certain debt funds.

Understanding the Cost Inflation Index (CII) and its role in indexation.

Index cost formula involves multiplying the original cost by the CII of the selling year and dividing by the CII of the buying year.

Calculating capital gain based on the index cost.

Example calculation of indexation benefit for a property bought in 2007 and sold in 2023.

Significant tax savings due to indexation benefit in the property example.

Indexation benefits available in various asset classes such as real estate and physical gold.

Changes in indexation benefits for debt funds before and after April 1st, 2023.

Indexation benefit calculation for mutual funds based on the purchase and sale dates.

Indexation reduces the tax burden on investors by adjusting asset prices for inflation.

Indexation is calculated using the Cost Inflation Index provided by the government.

Availability of indexation benefits in debt mutual funds invested before April 1st, 2023.

Summary of indexation's impact on reducing tax burden and its calculation method.

Transcripts

We often hear that

you get indexation benefits

on long-term capital gains,

but have you ever wondered

what exactly this indexation benefit is?

So in this video, we will talk about

what indexation benefit means

and how to calculate it.

Hello everyone, I am Aastha Khurana,

and welcome to Zerodha Varsity Videos.

Now let us understand indexation through

a simple story.

I had a limited edition watch

and I bought it on 25th September 2022.

Its price was ₹50,000.

Next year due to inflation

its price increased to ₹55,000.

My friend liked that

limited edition watch very much,

so I sold it to her for ₹60,000.

Now what will be my capital gain

in this case?

Capital gain has a simple formula.

From your selling price,

we subtract its buying price,

so 60000 minus 50000 is equal to 10000.

Now we will have to pay capital gains tax

on this ₹10,000.

But the thing to note is that

the actual price of that watch

increased to ₹55,000 due to inflation,

so we have to adjust it with inflation.

So now we will calculate

our capital gains tax.

So from the selling price,

we will subtract not the buying price

but its current price,

i.e. 60000 minus 55000.

Now this tax will be calculated at 5,000.

Now this process where we adjust

the buying price due to inflation

is called indexation,

and this adjusted price is actually

called index cost.

Now let us understand

what are the benefits of indexation.

First of all, the value of assets

is adjusted due to inflation.

Second, now that the value of these assets

is adjusted,

your tax burden gets reduced.

Thirdly, we get the benefit of

indexation on long-term capital gains,

hence it motivates investors

for long-term investing.

Now let's talk about some asset classes

where you get the benefit of indexation.

Real estate, physical gold or jewelry,

selling SGBs before maturity,

G-Secs that are directly bought

from RBI direct,

debt funds where equity exposure is

between 35% to 50%.

Now let us understand

how this indexation works.

For this, we will have to understand

the meaning of CII.

CII stands for Cost Inflation Index.

This is basically a number determined

by the government which reflects

the inflation of that year.

The year the inflation is higher,

this number will also be higher.

Every year the government uploads

its data on the Income Tax website,

the link of which will be found

in the description below.

Now the formula for indexation

or index cost is that

we multiply the original cost

by the CII of the given year

and divide it by the CII of the base year.

Now here by given year,

we mean the year in which you sold

your property or asset,

and by base year we mean the year

in which you purchased the asset.

Now we determine the capital gain

based on the index cost that we get.

Now to calculate this capital gain,

we will subtract the index cost

from the selling price.

Let us assume that Tina bought

a property worth ₹9 lakhs in July 2007.

Now when she wants to sell that property

in February 2023,

its value as of today's date is ₹1.05 crores.

So in such a situation,

Tina is getting a benefit of ₹96 lakhs,

and on this ₹96 lakhs,

Tina will have to pay tax

and that tax will be quite high.

But now because Tina was invested

in that property for more than 2 years,

she will get an indexation benefit.

So let us now calculate

what will be the indexation benefit

of this property

i.e. what will be the index cost.

Now we remember the formula of index cost.

The original cost is to be multiplied

by the CII of the given year

and divided by the CII of the base year.

Now here the given year is 2023

in which she is selling the property

and its CII number is 331,

and the year in which she purchased

the property which is 2007,

its CII is 129.

So when we do all this calculation,

the number we get is 23,09,302.

Now when we calculate our capital gain,

we will subtract this index cost

from our selling price.

So now the amount we have for

calculating capital gain is ₹81.9 lakhs.

Now with this benefit of indexation,

Tina could actually save ₹2,82,000.

Now we have understood

the meaning of index cost,

and with the help of this index cost,

we can also take the benefit of

indexation in various asset classes.

For example, real estate,

physical gold or jewelry,

government securities that are directly

bought from RBI Direct,

and debt funds where the exposure is

35% to 50%.

Now here you have to keep

two points in mind.

The first point is that

before April 1st,

debt funds were favorable

for many people because they had

the benefit of indexation.

Now the benefit of indexation

is not available on debt funds.

But if you were invested

in that debt fund or that mutual fund

before April 1st,

then you will get that benefit.

Apart from this,

whenever the benefit of indexation

is calculated for mutual funds

for other schemes,

your indexation benefit is calculated

by keeping in mind when you bought

and sold those units.

So from this video,

we learned that the prices of assets

are adjusted by inflation over a period,

and the process of this adjustment

is called indexation.

Due to indexation, the tax burden

on the investor is reduced.

Indexation is also calculated with

the help of the Cost Inflation Index.

And lastly, you can avail

indexation benefit in those

debt mutual funds which were invested

before 1st April 2023,

but after 1st April it is not applicable.

I hope you found this video of

indexation helpful.

See you in the next video,

till then happy investing.