What is Capital gains and indexation ?

What is Capital gains and indexation ?
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Over the last couple of weeks, we looked at how mutual funds are taxed. We spoke about indexation benefit being available for long term capital gains in debt funds. What is indexation benefit and how does it make debt funds a superior option to traditional products such as fixed deposits?

In traditional products such as fixed deposits or debentures, the interest on your investment is taxed in your slab rate; that is –whichever tax slab you fall under. With debt mutual funds too, your gains (short-term gains) are taxed at your slab rate if you held them for less than 3 years. But for investments held for over 3 years, you are taxed at 20% with indexation benefit. What does indexation do? It simply brings the cost of your investment to the current value, by considering cost inflation index. In other words, the value of your original investment is increased to the extent of inflation during your holding period.

Thus, by inflating your original cost, the gain (sale – indexed cost) actually comes down and you pay a 20% tax on such gain.

Let us take an example to see how this works:
You invested Rs 1 lakh in say January 2012 in a debt fund that delivered 9% annualised return in 4 years. At the same time, you also invested in a deposit returning 9% compounded return. Your deposit would have matured on December 31, 2015. Rs 1 lakh of investment will leave you with Rs 1,41,158 after 4 years. If you are in the 30% tax bracket, deposit money in hand, post tax would be Rs 1,28,810. You would have paid Rs 12,348 as taxes (not considering cess, surcharge etc.)!

Now let us come to the debt mutual fund. Having held the fund for 4 years, if you exit the fund (on the same day as your deposit) you will be allowed indexation benefit.

The indexation would be: your investment cost*cost inflation index in year of sale/cost inflation index in the year of purchase. So your indexed cost will be Rs 1,00,000*1081/785 = Rs 1,37,707. Your long-term gain is therefore 1,41,158-1,37,707= Rs 3,451. Tax on this is 3,451*20/100= Rs 690 and post tax money in hand is Rs 1,40,467.
(click here for cost inflation index table)

The table below makes it obvious how debt funds provide superior post tax returns as a result of indexation, assuming that both FD and debt fund earn the same (which is not the case as debt funds hold higher return potential).

Indexation

In some cases where the indexed investment amount is greater than your sale price and there is a capital loss for tax purposes. Such loss can be declared and also offset against any other long-term capital gain.

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