What is Indexation | Calculating Indexation on Capital Gains Tax

Indexation for Capital Gains Tax

Indexation plays a crucial role in the calculation of Capital Gains Tax. But what is this tax, and how does indexation affect it? Capital gains tax applies to any profits or gains from the sale of a ‘capital asset’. These assets include real estate, stocks, mutual funds, trademarks, and jewellery. Profits from the sale of these assets are considered as an ‘income’. As a result, you must pay a particular amount of tax on it. 

Capital gains tax is significantly influenced by indexation. Below is a detailed explanation for the same. 

Without Indexation:

Capital gains are calculated as follows without indexation. 

Capital Gains = Selling Price – Purchase Price

Without Indexation, you must pay tax on the entire difference, even if it is mainly due to inflation. 

With Indexation:

Capital gains are calculated as follows when considering the cost inflation indexation. 

Indexed Cost of Purchase = (CII of Purchase Year/ CII of Sale Year) x Original Purchase Price

In this case, you must pay tax only on the real gains and not on capital gains due to inflation, which reduces your capital gains tax. 

Cost Inflation Indexation 

The Cost Inflation Index (CII) is a government-declared index that adjusts the price of assets for inflation. It ensures fair capital gains taxation. The Income Tax Department of India updates the CII annually to reflect inflation trends. 

CII helps calculate the indexed cost of acquisition. Hence, it plays a crucial role in real estate transactions by reducing capital gains when selling a property. 

Applying CII helps you lower your tax liability in long-term capital gains. Hence, you will not be taxed on inflationary gains, making your real estate investments more tax-efficient. 

Cost Inflation Indexation figures 2001 to 2025

The role of indexation in real estate transactions is irreplaceable. Here are some of the most significant benefits: 

Reduces Capital Gains Tax Liability: The first benefit of Indexation is that it reduces tax liability by allowing you to pay only on real gains instead of on gains due to cost inflation. 

Encourages Long-Term Investment: It applies only to long-term capital assets. Therefore, it encourages holding your property for over two years to reap better returns. 

Helps in Tax Planning: It also helps you to plan your sales and purchases smartly. It allows you to optimise your transactions with tax savings. 

How to Calculate Indexation? 

Below is a detailed explanation of calculating Indexation using an example when selling a property. 

• Imagine you bought a property in the 2016-17 financial year for INR 50,00,000.

• Now, you decide to sell it in the 2024-25 financial year for INR 1,20,00,000. 

• So, the CII of the purchase year will be 264, and for the sale year, it will be 363.

• Therefore, Indexation will be calculated as follows. 

Indexed Cost = (CII in Purchase Year/ CII in Sale Year) × Original Purchase Price

Using the values:

Indexed Cost = (363/264) × INR 50,00,000

Indexed Cost = 1.375 x INR 50,00,000 = INR 68,75,000

LTCG = Sale Price−Indexed Cost 

LTCG = INR 1,20,00,000 − INR 68,75,000 = INR 51,25,000

In India, the Capital Gains Tax on long-term assets is 20%. 

Tax Liability (With Indexation) = 20% × INR 51,25,000 = INR 10,25,000

Tax Liability (Without Indexation) 

Capital Gain = INR 1,20,00,000 – INR 50,00,000 = INR 70,00,000

Tax Liability = 20% of INR 70,00,000 = INR 14,00,000

This explains the benefit of Indexation, as the tax liability is much higher without it. 

Latest Updates on Indexation Tax Benefits for Real Estate  

The Finance Minister of India, Nirmala Sitharaman, announced certain changes in Budget 2024 – 25, that allow you to calculate capital gains tax on real estate transactions using two options. 

• 20% Long-Term Capital Gains Rate With Indexation: Using the traditional method, you can also calculate your capital gains tax. This involves using indexation, and the tax rate is 20%. This allows you to adjust the property’s purchase price for inflation. 

Effective date: However this is only for properties bought before July 23, 2024. All properties purchased post this date, are liable to pay the LTCG taxation charges of 12.5% without indexation. (They do not have the option of 20% with indexation benefit)

For NRIs: Further for NRIs, this exception does not apply, and they have to pay 12.5% without indexation for all property transactions done post July 23, 2024.

The changes by the Indian Finance Ministry allow you to calculate your tax liability based on your financial situation. This ensures you are not affected by the indexation benefit removal.

Conclusion to Indexation

Indexation is a crucial tax-saving tool. It helps you reduce capital gains and tax liability. Using the cost inflation index, you can ensure you are taxed only on real gains instead of on gains due to inflation. This blog gives you a detailed look into how to calculate tax liability. 

However, you must consult a tax professional to help you understand better and form the right strategy to make your transactions tax-efficient. 

External References for Indexation