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• ⚠️ Before April 1st, 2023, debt funds had the benefit of indexation, but this is no longer applicable for investments made after this date.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.