What is indexation in capital gains

Assets creation is considered as one of the important achievements for any person. Once you have created an asset, its value appreciation or depreciation depends on the factors related to it. At the time of selling or disposing off such asset, one may have to bear loss or gain arising from the same.

Any gain or loss arising from the same is called as capital gains. Indexation in capital gain refers to the adjustment of the purchase price of an asset to account for inflation, thereby reducing the taxable capital gain when the asset is sold.

Budget 2024 Updates relating to Capital Gains:

On 23^rd July, 2024 Government had abolished the indexation benefit on long-term capital gains. In simple words, the purchase price of the asset will not be adjusted to current price after considering the inflation.

However, due to concerns raised by various taxpayers regarding possibility of arising higher capital gains, government has taken back the decision of abolishment of indexation. Now the government offers indexation benefit at a different tax rate than the rate applied for calculating gains without indexation benefit.

Meaning of Indexation:
The Income tax act, 1961 has provided provisions relating to adjustment of inflation while calculating gains from a capital asset. Purchase price of a particular asset is adjusted with the inflation at the time of selling that asset in order to calculate potential capital gains or losses. This is particularly applied to Long-term transactions of the assets. By applying indexation, tax liability can be reduced as the purchase price adjusted with inflation will turn out to be higher than its actual purchase price due to the formula applied for calculation.

Example:

Suppose you bought a property in 2005 for Rs.1,00,000 and sold it in 2023 for Rs.3,00,000. Let's assume the CII for 2005 was 117 and for 2023 was 331. 

Indexed cost of acquisition will be: 1,00,00 x (331/117) = Rs. 2,82,906.84

The capital gain would then be: 300,00−282,906.84= Rs.17,093.16

Without indexation the capital gain would be Rs.2,00,000 which is hugely higher than the calculated gain amount.

This indexation benefit is applied to various types of assets like stocks, mutual funds, debt funds, properties or immovable assets etc. Also, one has to remember that indexation benefit is applicable on not only acquisition cost but on improvement cost as well.

Taxation related to Indexation Budget 2024 updates:
Government has proposed a Uniform LTCG tax rate at 12.5%. Additionally, the holding period for determining whether a capital gain is short-term or long-term has been revised. Listed securities will now be considered long-term after 12 months, while other assets require a holding period of 24 months. This 12.5% tax rate is applicable when no indexation benefit is availed. 

However, Government has provided an option to the taxpayers to avail indexation benefits but at a higher rate of 20%.  Tax-free limit for long-term capital gains on equity-linked investments is raised from Rs. 1 lakh to Rs. 1.25 lakh

Conclusion:
Indexation benefit is used for adjusting purchase price with inflation at the time of selling an asset. This helps to reduce tax liability. However, Budget 2024 had initially removed indexation benefit offering a 12.5% LTCG tax rate across all types of assets, it is now again restored at 20% tax rate on LTCG with indexation.