What is Indexation in Taxation
January 30 , 2013

The computation of capital gains in any buy and sell transaction involves arriving at the purchase and sale value. The sale value, unfortunately, is not too malleable. But if an asset or investment is held for the long term (long term being defined differently for different assets / investments), the government allows an adjustment of purchase value upwards, to account for inflation. This is called indexation, and typically reduces your capital gains tax liability.

For instance, if you sold a house for Rs 30 lakh, and had purchased it for Rs 15 lakh five years earlier. You use what is called a cost inflation index (tables given below) to arrive at the effective purchase value of, say, Rs 20 lakh. Then your capital gains number used for calculating tax liability is only Rs 10 lakh, thanks to the indexation benefit.

Consider the following transactions in your house:

Date of purchase

15 June 1995

Purchase price (including registration, stamp duty and brokerage)

Rs 20 lakh

Date of sale

30 September 2008

Sale price (after subtracting brokerage)

Rs 65 lakh

 Now assume we want to calculate the capital gains tax applicable on this. The steps are as follows:

1. Recognise that purchase is in FY1995-96 and sale is in FY2008-09. Since the difference is more than 3 years (refer the ready reckoner on tax), it is a long term capital gain and there will be benefit of indexation available

2. Look up the ready reckoner for the Cost Inflation Index (CII) for these two years. In our case, it is 281 and 582, respectively

3. Calculate the indexed cost of acquisition

 Indexed Cost of Acquisition = Actual Purchase Price X  Indexation Factor

Where Indexation Factor is  calculated as follows:

 Indexation Factor = Cost inflation index of the year of sale / Cost inflation index of the year of purchase

4. Calculate the long term capital gains (LTCG)

 Long Term Capital Gain = Sale Price – Indexed Cost of Acquisition

5. Look up the ready reckoner to note that LTCG rate on real estate is 20%. Thus:

 Tax = 20% of Long term capital Gain calculated

Thus, your capital gains tax liability from the sale of the house is Rs 4.72 lakh

Some useful points to note:

  • As always, capital gains tax is only payable when an asset is sold
  • This being long term capital gains, there are ways to avoid the tax liability. These ways include tax saving bonds and investing in another residential real estate
  • Note that all expenses related to purchase are included in the purchase price. Similarly, all expenses related to sale are subtracted from sale price. This helps reduce your tax liability.

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