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How does indexation benefit work?

The basic idea behind the concept of indexation is that inflation eats into returns and tax should be paid only on the real gains

Please help me to understand the meaning of indexation benefit. Please explain it with an example.
- Sachin Handa

The basic idea behind the concept of indexation is that inflation eats into returns and tax should be paid only on the real gains. Based on this, investors have the option of paying long-term capital gains at the rate of 20 per cent with indexation benefits. In order to make the computation of the actual gains, the government constructs an index called the cost of inflation index. This index has its base year as 1981-82 and the value for that year is 100. The value of the index is declared for each financial year.

The formula to calculate capital gains with the help of indexation is : sale price - indexed cost of acquisition.

The formula to calculate indexed cost of acquisition is: purchase price x cost inflation index of the year of sale/cost inflation index of the year of purchase

You can get cost inflation index from the Income Tax website.

Here is an example. Suppose you have invested ₹1 lakh in financial year 2012 and sold your investment and got ₹1.2 lakh in financial year 2015.

Your indexed cost of acquisition is : ₹1 lakh (purchase price)X 1024 (cost inflation index of the year of sale)/ 785 (cost inflation index of the year of purchase) = ₹1,30,445.9

Long term capital gains is: 1,20,000 (sale price) - 1,30,445.9 (indexed cost of acquisition) =-10,445.9

As you can see, the indexation has resulted in a long-term capital loss here. Long term capital loss arising out of sale of assets can be set off against long term capital gains arising from sale of any asset. However, long term capital loss from sale of shares and mutual funds where Securities Transaction Tax (STT) is paid can't be set off against any other capital gains. Long term capital loss can be carried forward for eight years.

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