Indexation: Everything you wanted to know

The profit earned through the sale of property, attracts tax under the Indian Income Tax Act. However, the owner can significantly lower his outstanding tax liability on the proceeds earned by using indexation.

An effective method to lower your tax liability on returns earned through the sale of long-terms assets such as property, indexation is also applicable on debt funds and other assets under the prevalent tax laws in India.

What is indexation?

Since all income in India is taxed, there are high chances of you losing a substantial portion of your gains, in paying taxes on such income. However, indexation offers you the option to lower this tax liability, thereby, helping you save more. Now, how does this work? Applicable on long-term investments such as property and debt funds, indexation helps you adjust the cost of acquisition of the asset against inflation. When indexation benefit comes into picture, the cost of purchase increases significantly, in effect lowering your tax outgo and increasing your savings.

Now, before we proceed to understand how indexation can help home buyers, it is imperative to have clarity on two other concepts – inflation and capital gains.

What is inflation?

Inflation is the decline in the purchasing power of a given currency over time, against the rise of worth of goods and products. For example, buying a property for Rs 10 lakhs may have been possible in, say, Delhi, in the 1970s. For the same amount of money, you will not be able to secure a property in 2020, since the worth of Rs 10 lakhs has declined over the decades and the worth of property has increased disproportionately. That is inflation. In effect, inflation lowers the currency holders’ purchasing capacity.

What are capital gains?

Capital gains refers to the appreciation in the value of goods and products, over a specific time period. If you bought a property for Rs 10 lakhs in 2010 and you now have buyers willing to pay Rs 20 lakhs for it in 2020, the difference of Rs 10 lakhs is its capital gains in the 10-year period. The difference between the selling and the purchase price of an asset is defined as capital gains.

If a property was held by the owner for less than two years before its sale, the gains thus earned will be considered as short-term capital gains (STCG). This profit gets added to the seller’s other income and is taxed according to the IT slab rate applicable. If the property was held for more than two years at the time of its transfer, the profits are considered as long-term capital gains (LTCG) and taxed at the rate of 20%, with indexation. To calculate the LTCG from the property, the seller has to calculate the indexed cost of acquisition. Now, to arrive at this number you will have to use the cost inflation index (CII) for the year of the sale and the purchase.

See also: What are capital gains?

What is indexation?

Indexation refers to the process of adjusting the purchase cost of an asset, for inflation. Indexation allows the tax payer to factor in the impact of inflation on the historical cost of acquisition. This effectively lowers the amount of capital gains that would be taxed.

Suppose you bought a property for Rs 10 lakhs in 2013-14 and sold it for Rs 50 lakhs in 2020. If the tax authorities were to compute the capital gains on this profit, you will have to pay a LTCG on a profit of Rs 40 lakhs. With the indexation benefit coming into picture, the cost of acquisition would also increase in proportion to the spike in inflation as shown under the government’s CII. The indexed price so arrived at, is used to calculate the capital gains and would then be taxed at 20% or 10% plus surcharge and 4% education cess.

Formula for computing indexed cost

To obtain the indexed cost of the property, multiply the purchase price with the CII for the year in which the sale is made and then, dividing it by the CII for the year when it was purchased.

The formula for computing the indexed cost (or inflation-adjusted cost price) is:

(CII for the year of sale/CII for the year of purchase) x actual purchase price

See also: How indexation affects long-term capital gains tax calculations

Cost Inflation Index (CII)

CII is an index used to calculate the notional increase in the value of an asset due to inflation.

One can view the CII from 1981 onwards. The CII for each financial year is available on the IT website, incometaxindia.gov.in.

CII applicable from financial year (FY) 1981-82 to FY 2016-17

Source: Income Tax Department

CII from FY 2001-02 to FY 2020-21

Section 55 of the IT Act was amended through the Finance Act 2017, to establish that the cost of purchase of an asset acquired before April 1, 2001 will be allowed to be taken as the fair market value and the cost of improvement will include only those capital expenses which were incurred after that date.

The CII for long-term capital assets sold after April 1, 2017, as notified by the CBDT are:

Source: Income Tax Department

Indexation benefit for home buyers

Suppose a property was purchased in FY1992 for Rs 20 lakhs. The CII for that year is 199.

Suppose this property was then sold for Rs 80 lakhs in FY2009. The CII for that year is 582.

Now, applying the formula for indexed cost, we get:

(CII for the year of sale/CII for the year of purchase) x actual cost

= (582/199) x Rs 20 lakhs = Rs 58.49 lakhs.

This means the seller will have to pay long-term capital gains tax on the difference between Rs 58.49 lakh and Rs 80 lakhs, after applying the indexation benefit. That way his LTCG liability will be Rs 21.51 lakhs.

See also: How to save on long-term capital gains tax

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