InvestorQ : What is indexation and How it helps in saving tax while selling my mutual funds?
Nitin Shah made post

What is indexation and How it helps in saving tax while selling my mutual funds?

rhea Babu answered.
2 years ago
Capital gains on investing in debt funds are taxable in India. If you sell your investments in debt funds after 3 years, the gains are treated as capital gains and are subject to a Long-term Capital Gains Tax (LTCG) of 20% with indexation benefit. Indexation allows for inflating the purchasing price of an asset taking into account the cost inflation index (CII), in effect reducing the taxable corpus.  Inflation erodes the value of the asset over time. 

For eg: the actual value of Rs 3,000 over 5 years, assuming an annual rate of inflation of 5%, would be Rs 2,321.  Hence it must be taken into account when computing tax on the difference between the buy and sell cost. Indexation takes inflation into account during the holding period of the asset and raises its acquisition price accordingly. This reduces the overall gains and, consequentially, pulls down tax outgo. 

To better understand the benefit of indexation, let us look at an example. 

Suppose you have invested Rs1lakh in a debt mutual fund scheme in January 2015 and sold it for Rs 1.4lakh in June 2017. Since the investment was held for more than three years, it qualifies for long term capital gains taxes with indexation benefit. 

To calculate the indexed cost, you would need CII of two financial years- The financial year in which the units are purchased (2014-2015) and the financial year in which it was sold (2017-18). CII is decided on a financial year basis. 

The mathematical formula to attain inflation-adjusted cost price is as follows:
Indexed cost= (CII for yr of sale/CII for yr of purchase) * (Cost of purchase)
i.e. Indexed cost = (272/240) * 1,00,000 =Rs1,13,333
Thus, your taxable long-term gains after indexation= Rs26,667.  This is comparatively lesser than the actual gain of Rs40,000.

This indexation benefit is applicable only to debt mutual funds and is claimed at redemption.