Using Indexation to Lower Your Taxes

You might have heard of the term indexation in the context of investments and taxes but may not be fully aware of what it is, why it matters or how to utilise it. Given how much money this lack of understanding may be costing you, let’s try fixing that.

We know that money loses its purchasing power every day because of inflation. The cost of living keeps increasing over time; what ₹100 could get you 5 years ago, they will not get you today. To soften the blow of inflation, the Government allows one to avail of indexation benefits for your investments to reduce the tax burden. Indexation refers to adjusting the purchase price of your investment to reflect the current cost of living. This upward revision reduces the on-paper profits and thereby your tax liability.

Each year, the Central Government declares a number called the Cost Inflation Index (CII), from which the word “indexation” comes. CII reflects the impact of inflation¹ on the purchasing power of money. As of 2021, the reference or base year is considered to be 2000 and its value is pegged at 100.

The Income Tax department publishes the CII table for reference and revises it each year.

Using the CII table, you can calculate the indexed purchase price using the formula below

$$\textit{indexed purchase price} = \textit{purchase price} * \frac{\textit{CII for the sale year}}{\textit{CII of the purchase year}}$$

The Long-Term Capital Gains (LTCG), i.e. the amount on which you need to pay taxes, is

$$\textit{selling price} - \textit{indexed purchase price}$$

As an example, let us consider that you invested ₹100 five years ago i.e. in 2015 and sold it today at ₹150, for a profit of ₹50. Let us also consider that you have a marginal tax rate of 20%.

With indexation, your tax liability reduces from ₹10 to ₹6.3, for an effective tax rate of 12.6% — a whopping 37% reduction!

You might be inclined to make this inflation adjustment for all your investments, and I would not blame you for it is too tempting. However, indexation benefit is available only for:

1. Specific investment classes
   Some of the investment classes that are covered include:

   • Domestic debt mutual funds
   • Foreign equity, including mutual funds/ETFs
   • Movable property such as gold, jewellery, paintings etc
   • Immovable Property, such as a house
     Expenses incurred in relation to renovations of or extensions to a house too can be inflation adjusted in a similar manner.

   These are also the ones that are charged higher tax rates to begin with. Fixed deposits, importantly, do not enjoy this preferential tax treatment. Domestic equity investments, having a 10% LTCG tax rate, are not covered either.

   Fixed deposits, importantly, do not enjoy this preferential tax treatment.

2. Long-term investments
   The shortest holding period for an investment to be classified as long-term varies based on its type but is at least 24 months: some categories need to be held for 36 months or more. If you sell before the LTCG cutoff date, the profit gets categorised as Short-Term Capital Gains (STCG) and you can not avail of the benefit.

How to make the most of indexation?

There are three situations where you must keep this benefit in mind:

1. Filing for taxes
   This one is obvious. Do not forget to check if your investments qualify for inflation adjustment. I am pretty sure you do not want to pay more taxes than you must!

2. Deciding when to sell
   Think twice before selling an investment if the cutoff date for its classification as LTCG is approaching. Delaying the sale a little can reduce the applicable tax, if you are in the highest tax tier, from 30% to less than 20%.

3. Choosing where to invest
   This is an often ignored but the most interesting and important implication. The large reduction in payable taxes because of indexation makes certain investment classes far better options compared to others e.g. Debt mutual funds over Fixed Deposits.

I hope that now you understand the indexation benefit and how to take advantage of it to save taxes and to pick the right asset classes.