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As we know, inflation is the general rise in the prices of goods and services over time. This directly or indirectly impacts the purchasing power of the consumers.
In the field of investments, it is thus necessary to take inflation into account while calculating the returns of an investment.
So, how do we adjust the inflation into our investments?
It is basically done through a method called Indexation. Indexation in basic terms denotes adjusting or recalculating the purchase price of any asset after adjusting the cost inflation index. This cost inflation index is published by the Income Tax authorities.
By adjusting the purchase price of any asset with the inflation index the price gets readjusted or bloated (which means it is considered at the current price levels). Let’s see an example:
Suppose we have bought an asset in 2005 at 2 lacs and sold the same asset in 2018 at 7 lacs. Then, we need to refer to the Cost Inflation Index published by the Income Tax of India.
We will extract the CII of the year 2005 when the asset was bought (CII=113) and the year when the asset was sold i.e in 2018 (CII=272). Then when we divide the CII of 2018 by CII of 2005, we would get 2.40.
This value is then multiplied by the purchase price (2 lacs * 2.40) in order to arrive at the indexed purchase price of the asset (4.81 lacs). This is basically called as the indexed purchase price of the asset.
Now, what is the benefit to calculate this price?
If you would have noticed, that the purchase price has actually increased to that of the actual price. In 2005, the actual price was 2 lacs but upon indexation it is 4.81 lacs.
Upon calculating the capital gains taxes, this indexed price would show lower long-term gains and so, one would have to pay less LTCG (Long Term Capital Gains) on its investment returns.
Suppose, we just deduct the cost price from the sales (7lacs – 2 lacs), then we would get a capital gain of 5 lacs. But due to the factor of inflation this is not the correct measure to calculate the capital gains. Hence, once we have taken the indexation benefit, our capital gain would arrive at (7 lacs – 4.81 lacs= 2.18 lacs).
Lower capital gains would reduce the taxable income and also help us as an investor earn higher post tax returns.
Now, one thing we should also note that equity funds do not offer the Indexation benefits in India. Indexation benefits can be found in only in debt mutual funds. This indexation benefit gives the debt funds an edge over any fixed income investments such as bank deposits in terms of post-tax returns.
So, indexation benefit in debt funds is more of like an exclusive sale in any retail mart store where you know that you would be charged less for the same thing available at some other place.
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