What is indexation on investments and how can it help you on saving taxes this financial year?

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Indexation is one of the most important principal to know if you are an investor in real estate, mutual funds, direct equity i.e. in almost all investment instrument of relevance. Indexation is one of the key factors (for saving taxes), effective use of which can reduce your tax burden significantly.

Following is a technical understanding of Indexation:

Indexation is a technique used to adjust the purchase price of certain types of investments for inflation. For ex: If you bought a house at Rs. 10,000 in 2001 and you sold the house for Rs. 2 Lacs in 2015, ideally you made a profit of Rs. 1.9 Lacs and most people would think that you are supposed to pay income tax on this Rs. 1.9 Lacs. However, income tax department recognises that one needs to increase the purchase price of the asset so that it reflects inflation-adjusted true price in the year in which it is sold, and hence your profit will not be Rs. 1.9 Lacs but it will be (2 lacs – inflation adjusted or indexed price of the house in 2015) and you will pay tax only on that amount.

To understand indexation let’s understand one more technical term – Capital Gains.

Capital Gains is nothing but profit you made on your investment due to the increase in the value of investment be it real estate, mutual funds, gold, shares etc. However, Capital Gains is not defined for most fixed income instruments like Fixed Deposits, NSCs Kisan Vikas Patra etc.

There are 2 kind of Capital Gains – 

a) Long Term Capital Gain and

b) Short Term Capital Gain

Difference between the two is only in terms of duration i.e. the Capital Gains you made after holding your investment for what amount of time, and the duration can vary from one investment instrument to another. For ex:

In Debt Mutual Funds if you have remain invested for more than 3 years, all the interest you earned will be classified as Long Term Capital Gains and if you withdraw your investments in less than 3 years then your interested earned will be classified as Short Term Capital Gains.

In Equity Mutual Funds, the same time period is only 1 year i.e. if you have remain invested for more than 1 year, all the interest you earned will be classified as Long Term Capital Gains and if you withdraw your investments in less than 1 year then your interested earned will be classified as Short Term Capital Gains.

In Debt Mutual Funds, if your gains are short term, you have to pay taxes on your entire interest in line with highest bracket of your taxation. However, if your gains are long term there is indexation benefit and you only have to pay 20% on the profit you earned after indexation.

To understand how it works, below is an example

Your annual taxable salary is Rs. 12 Lacs and you invested Rs. 1 Lac in Reliance Money Manager Debt Fund via FinoZen in 2013, now after 1.5 year your current balance becomes Rs. 1.2 lacs and you withdraw your entire investments along with interest earned. At the end of the financial year i.e. in March when you are filing your taxes, you will have to pay 30% (i.e. the highest taxation bracket you are in) * 20,000 (interest you earned on your investment) = Rs. 6,000. This Rs. 20,000 is considered as short term capital gain.

However, if the same user remain invested for 3 years and his value of investment becomes Rs. 1.5 lacs in 2016, and he withdraws his entire investment then, this Rs. 50,000 earned will be considered as long term capital gain and the calculation of his taxable gains will be as follows –

(Rs. 1.5 Lacs – (Rs. 1 Lac*1125/939)) = Rs. 30,192

Tax liability will be = 20% * Rs. 30,192 = Rs. 6,038

i.e. the tax liability hasn’t changed even though the interest earned is 2.5 times higher. This is the power of indexation.

Understanding Indexation Benefit and Long Term Capital Gains will help you choose the right investment because taxes are an important consideration while investing.

For equity mutual funds, short term capital gains is charged at 15% while long term capital gains are free of taxation.

Now, how can you index your investments on your own? – Use Cost Inflation Index Value (like we used in the example above).

As per Income Tax Act, Cost Inflation Index (CII) is a measure of inflation that is used for determining the indexed cost of acquisition. This is published every year for the financial year and is available on the website of the income tax department. The below table reproduces these values –

Financial Year Cost Inflation Index Financial Year Cost Inflation Index
1981 – 82 100 1999 – 00 389
1982 – 83 109 2000 – 01 406
1983 – 84 116 2001 – 02 426
1984 – 85 125 2002 – 03 447
1985 – 86 133 2003 – 04 463
1986 – 87 140 2004 – 05 480
1987 – 88 150 2005 – 06 497
1988 – 89 161 2006 – 07 519
1989 – 90 172 2007 – 08 551
1990 – 91 182 2008 – 09 582
1991 – 92 199 2009 – 10 632
1992 – 93 223 2010 – 11 711
1993 – 94 244 2011 – 12 785
1994 – 95 259 2012 – 13 852
1995 – 96 281 2013 – 14 939
1996 – 97 305 2014 – 15 1024
1997 – 98 331 2015 – 16 1081
1998 – 99 351  2016 – 17  1125

If you have any question on this, ask us in the comment below.

Author: Varun Gupta

Varun is the CEO of FinoTrust.com and FinoZen.

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