Indexation Reduces Tax liability

If you have recently sold a property or redeemed a debt fund then you are liable to pay income tax on Capital Gain. The gain will be counted in your regular income tax slab if it is short term gain but you may avail the power of indexation if it is long term capital gain. The gain is considered long term if you stayed invested for more than 3 years and it is available on certain investments (Debt Funds, real estate, equities, certain mutual funds etc.).

Let’s consider that Mr F invested Rs 10000 in a Debt Fund in financial year 1999-2000 for 10 years with annual rate of return at 10% per annum.

Since this investment is longer than 3 years and it is a Debt Fund, this investment qualifies to be Long Term Capital Gain. Mr F has two options to pay tax on LTCG

  1. Pay 10% tax on capital gain without considering indexation or
  2. Pay 20% tax on capital gain after considering indexation

Let’s calculate the tax liability.

Indexation Reduces Tax Liability

1. Without indexation

Investment = Rs 10,000

Return = Rs 25,937

Tax due at 10% = (25,937-10,000) * 10% = Rs 15,937

2. With indexation

Investment in year 1999-2000 = Rs 10,000

Return in year 2009-2010 = Rs 25,937

Cost Inflation Index in Year 1999-2000 = 389

Cost Inflation Index in year 2009-2010 = 632

Inflation adjusted investment = (CII in year 2009-2010)/(CII in year 1999-2000) * investment = 632/389*10000 = 16,246

Inflation adjusted gain = 25,937-16,246 = Rs 9,691

Tax due at 20% = 9,691 * 20% = Rs 1,938


Mr F saved a tax of 15,937-1,938 over not considering indexation = Rs 13,999 or 88% of tax.

Beware, if you are selling your property within 3 years of buying it because that will not only take away your option of using indexation for tax saving but also cause the gain to be added to your income. If you happen to be in 30% tax slab then you may be liable to 30% tax on this capital gain.


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