Indexation takes into account the inflation during the investment period and accordingly adjusts the purchase price of an asset. If you invest at the end of a financial year (say, March 2021) and redeem 37 months later in April 2024, you will get an indexation benefit for four years. During high inflation, this can reduce tax to zero.
Every year, the government announces a cost inflation index (CII) number for each financial year. The indexed cost of an asset can be calculated by the formula given above. The long-term capital gains tax is 20% plus surcharges. But indexation helps in reducing the tax by adjusting upwards the purchase price which cuts the long-term capital gains.
Calculating indexed cost
Indexed cost = (Purchase price x CII of year of sale)/CII of year of purchase
The Cost Inflation Index has shot up in recent years
However, not all investments are eligible for indexation benefit. Instruments such as bonds and debentures that mention an interest rate are not eligible for indexation benefit. This is why savvy investors opt for debt funds instead of fixed deposits where the interest is fully taxable at the rate applicable to the individual.
