Attributing to the rise in inflation, it has become a requisite to have sufficient investments in order to meet your needs. With inflation causing a ruckus in the global economy, investors have begun expanding their orbit and stepping into non-traditional investments to keep up with the pace of rising expenses. Among various channels that provide returns adapting to the rate of inflation, you might have already heard of debt mutual funds. But did you know that the long-term capital gains received from debt investments are taxed at an indexed value?
This means that you will be taxed on your returns only after taking inflation into consideration. But before we dive into the concept of indexation and understand how to calculate it, let us first learn the correlation between inflation and capital gains
The concept of inflation
Inflation causes a gradual decline in the purchasing power of individuals. It is the increase in the prices of goods and services over time. For instance, if you purchase a particular product today, the same product will be available at a higher price for the same or even a lesser quantity in the next few years. This increase in the prices of goods and services is called inflation.
To keep up with the increasing inflation rate, it becomes crucial for individuals to receive inflation-adjusted returns. Similarly, even the tax applicable on the profits earned from these investments needs to be calculated after considering the effect of inflation. Here is where the concept of indexation comes into the picture. It is used to calculate and reduce the burden of your tax liability over your capital gains.
What are capital gains?
Let us understand this with an example. Suppose you had purchased a debt fund at the NAV of Rs. 15, in 2019. If you redeem your investment at the present value in 2023, which let’s assume is Rs. 25 per unit, the value of your investment increased by Rs. 10 per unit. This increase in the value of your asset is your capital gain.
In the case of long-term capital gains where the debt fund is held for more than 36 months, the total gains will be taxed at 20% with the benefit of indexation.
Note that indexation will not be provided for short-term funds or equity funds.
What is Indexation?
Indexation helps you to adjust and reduce your tax liability on the long-term capital gains that you have earned from your debt investments. It basically reduces your profit by adjusting it with inflation. This in turn lowers your taxable income.
The concept of indexation only gives a fair view of your tax liability and prevents you from paying more than you need to. As a result, the benefit of indexation makes debt funds a more lucrative investment avenue.
The rate of inflation used for calculating the indexed value can be obtained from the Cost Inflation Index (CII) data which is available on the income tax department’s website. It is notified by the central government in the official gazette. It estimates the inflation rate and tries to match it with the prices. In simpler words, it adjusts the purchase price to the sale price that has increased because of inflation.
The CII is calculated by comparing the index of all the subsequent years to the base year. The base year is the year in which the index value is 100. Currently, the base year is 2001.
The CII table for the past few financial years is as follows:
|Sl. No.||Financial Year||Cost Inflation Index|
How to calculate the taxable income?
Let’s assume that you invested in a debt fund during the financial year 2014-15.
CII during the year of purchase = 240
Investment amount = Rs. 10,000
NAV = Rs. 10
You redeem your investments during the financial year 2018-19
CII during the year of sale = 280
Investment sold at = Rs. 30,000
NAV = Rs. 30
So, your capital gains will be sale price – purchase price = Rs. 20,000
But with the benefit of indexation, you won’t have to pay taxes on the entire 20,000 rupees. However, note that indexation will be calculated on this debt investment only because it was held for more than 36 months.
The formula for indexed cost of acquisition = Original cost of acquisition x (CII of the year of sale/ CII of the year of purchase)
As per our example, ICoA = 10,000 x (280/240) = 11,667
Hence, your capital gains will be considered as 30,000 – 11,667 = 18,333
Therefore, your tax liability will be computed on Rs. 18,333 instead of Rs. 20,000. This is how indexation helps you to save on taxes.
Indexation is a great way to boost your savings by lowering the tax on your long-term profits. Since debt funds provide inflation-adjusted returns as well as the benefit of indexation over long-term investments, it gives investors an edge over traditional investment options like fixed deposits. However, make sure to invest in a debt mutual fund only after evaluating the credit rating, yield to maturity, concentration of risk, etc. You can also consult a finance expert who will lay out a suitable plan for you, based on your risk appetite, objectives, and preferences. This will give you the confidence to make the right investments and maximize your savings.
Disclaimer: The views expressed in the blog are purely based on our research and personal opinion. Although we do not condone misinformation, we do not intend to be regarded as a source of advice or guarantee. Kindly consult an expert before making any decision based on the insights we have provided.
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