What is indexation in Capital Gain tax?

Indexation is a method used to adjust the cost of an asset for inflation when calculating longterm capital gains tax. In India, indexation is applied to assets other than listed equity shares and equityoriented mutual funds, such as real estate and debt mutual funds.

The indexation benefit allows you to adjust the cost of acquiring the asset by applying the cost inflation index (CII) published by the Central Board of Direct Taxes (CBDT). The CII is a measure of inflation and represents the annual inflation rate as determined by the government.

By applying indexation, the cost of the asset is adjusted upwards to account for inflation over the holding period. This adjustment helps in reducing the taxable capital gains, as the increased cost basis lowers the taxable profit.

The formula for calculating indexed cost of acquisition is:

Indexed Cost of Acquisition = Cost of Acquisition x (CII of the year of transfer / CII of the year of acquisition)

The indexed cost of acquisition is then subtracted from the selling price of the asset to calculate the indexed longterm capital gains. The indexed longterm capital gains are then taxed at the applicable longterm capital gains tax rate (currently 20% plus applicable surcharge and cess).

Indexation provides relief from the impact of inflation on longterm capital gains and helps in reducing the tax liability on such gains. It helps ensure that you are taxed only on the real gains, adjusted for inflation, rather than the nominal gains due to the rise in the overall price level over time.