Capital Gain Index
Indexation plays an important role in calculating the gains or losses in your investments. In this article, we will be learning about capital gains, indexation, and how they are calculated in mutual funds.
When we invest in any investment instrument, our main focus is to earn higher returns. Before we invest in any mutual fund, we take a look at the returns, and sometimes, we assume that the return that is shown next to the fund is what we will actually receive, completely ignoring the effect of taxation. However, the truth is, it is the post-tax returns that should matter the most.
Calculating the post-tax return might seem like a difficult task, as different rules and rates apply to various investment instruments. On top of that, taxes can eat into your returns. So, in this article, we will learn about indexation, which helps reduce your taxes.
Before we learn about indexation, we must learn about capital gains.
What Is Capital Gains?
Generally, capital gains refer to the gains or profits an individual makes on the sale of any capital assets. These could either be financial or non-financial assets. Financial assets are those that are non-physical or intangible in nature such as bonds, stocks, deposits, mutual funds, etc., Meanwhile, non-financial assets can be any physical item, which ranges from property, automobiles, etc.,
For example, You bought a house for ₹75 lakhs in October 2014. The full value of consideration in the financial year of 2017-18 was ₹2.1 crore. The house was held for more than 24 months, and hence, it is deemed a long-term capital asset. After considering the cost of improvement, and considering inflation, the cost price was adjusted, and the indexed cost of acquisition was also taken into account. The adjusted cost of the property was then settled at ₹1.4 crores.
This means you have accumulated a net capital gain worth ₹65 lakhs. After a long-term capital gains tax rate of 20% was levied on the net capital gain, the tax liability that was calculated to be paid would be around ₹13 lakhs. But there are also exemptions that are provided by the tax authorities which can offset the gains and the amount of tax to be paid if managed in the right way.
What Are The Types Of Capital Gains Taxation?
Based on the holding period, capital gains can be classified into the below two categories.
- Short-Term Capital Gains (STCG)
Any asset that is held for less than 36 months is termed a short-term asset. In the case of immovable properties, the duration is 24 months. The profits generated via the sale of such an asset would be treated as short-term capital gain and it would be taxed accordingly.
- Long-Term Capital Gains (LTCG)
Any asset that is held for more than 36 months is termed a long-term asset. The profits generated via the sale of such an asset would be treated as long-term capital gain and it would attract tax accordingly.
What Are The Types Of Capital Gains Taxation On Mutual Funds?
Capital gains in mutual funds refer to any profit or gains that the investors make on the sale or redemption of their mutual fund investment units.
Short-Term Capital Gains On Mutual Funds
Generally, short-term capital gains with respect to mutual funds, are the gains or profits an investor makes on the sale of their mutual fund investments if the holding period is less than twelve months. However, short-term capital gains can be acquired in both equity mutual funds and debt mutual funds.
STCG For Equity Mutual Funds - If an investor makes a profit on the sale or transfer of their equity mutual fund units before one year, the profits are termed as short-term capital gains.
STCG For Debt Mutual Funds - If an investor makes a profit on the sale or transfer of their debt mutual fund units before the completion of three years, the gains are termed short-term capital gains.
Long-Term Capital Gains On Mutual Funds
Long-term capital gains with respect to mutual funds are the gains or profits an investor makes on the sale of their mutual fund investments if the holding period is longer than twelve months. Just like short-term capital gains, long-term capital gains can also be acquired for both equity mutual funds and debt mutual funds.
LTCG For Equity Mutual Funds - If an investor makes a profit on the sale or transfer of their equity mutual fund units that we held for over one year, the gains are termed long-term capital gains.
LTCG For Debt Mutual Funds - If an investor makes a profit on the sale or transfer of their debt mutual fund units that we held for more than three years, the profits are termed as long-term capital gains.
What Are The Taxation Of Capital Gains On Different Types Of Mutual Funds?
We have explained how both long-term and short-term capital gains are taxed on mutual funds. Now, we will explain how capital gains are taxed for different types of mutual funds.
Taxation Of Capital Gains Of Equity Mutual Funds
Equity mutual funds invest 60% of their assets in a variety of companies in suitable proportions. The asset allocation will be in line with the investment objective. The assets will be allocated purely in stocks of large-cap, mid-cap, or small-cap companies, depending on the market conditions.
Short-Term Capital Gains Tax
When you redeem your investments from equity mutual funds within one year, the short-term capital gains are taxed at a flat rate of 15%, irrespective of your income tax bracket.
Long-Term Capital Gains Tax
If you redeem your investments from equity mutual funds after a holding period of one year or more, you will be subject to long-term capital gains tax. Capital gains of up to ₹1 lakh a year are exempted from tax. If your long-term capital gains exceed this limit, you will have to pay the LTCG rate at the rate of 10%, with no benefit of indexation.
Taxation Of Capital Gains Of Debt Mutual Funds
Debt mutual funds are mutual fund schemes that invest predominantly in fixed income-generating securities like Commercial Papers (CP), Certificates of Deposit (CD), Corporate Bonds, T-Bills, government securities, and other money market instruments. These instruments have a fixed maturity date and interest rate, which the buyers could earn until the maturity of the security. Debt mutual funds are considered to be less volatile than equity funds.
Short-Term Capital Gains Tax
When you withdraw your investments from debt mutual funds within a holding period of three years, the gains you receive are called short-term capital gains. These gains are added to your taxable income and taxed at your income tax slab rate.
Long-Term Capital Gains Tax
When you withdraw your investments from debt mutual funds after a holding period of three years, the gains you receive are called long-term capital gains. These gains are taxed at a flat rate of 20% after indexation. Post this, applicable cess and surcharge will also be levied on your tax.
What Is Indexation?
Indexation is a systematic process that enables individuals to protect their earnings against tax erosion. In simple words, indexation is an efficient way of preventing the draining of your returns on investments in the form of taxes. Indexation is applicable to long-term investments, including debt funds and other asset classes.
Thinking about how indexation can help you? Let us explain to you with an example. Let's say you invested ₹1 lakh during 2015-16 in a debt fund and redeemed ₹1.35 lakh during the year 2020-21. The absolute returns generated by you from this investment is ₹35,000. However, considering the holding period of around 5 years for an investment in a debt fund, you are eligible for an indexation benefit.
The indexed cost of investment will come out to be ₹1.19 lakh (₹1 lakh x *301/254). Hence, the taxable long-term capital gains (LTCG) on this investment by you will be calculated as ₹1.35 lakh minus ₹1.19 lakh (i.e.) ₹16,000. Therefore, you would be required to pay a tax of ₹16,000 which will be ₹3,200 (20% on ₹16,000).
*These numbers are taken from the Cost Inflation Index (CII). We have written a detailed article about CII and how it works. Please read it to get a complete picture of what CII is and how it is calculated.
This is how indexation helps the investors reduce the effective tax incidence on the returns generated from non-equity debts (i.e.) debt funds, etc. and consequently increasing the post-tax returns.
Where Is Indexation Applicable?
Indexation benefit is applicable only where the capital gains are long-term in nature. So, how do you define long-term? Well, it depends on the asset.
For exchange-listed equity assets, which include equity funds, long-term means staying invested for more than 12 months. On the other hand, for listed debt securities such as bonds, long-term is a holding period beyond 12 months and for unlisted debt securities, which include debt mutual funds, long-term is considered after you have stayed invested for at least 36 months.
For unlisted equity shares, the long-term investment horizon is when you stay invested for at least 24 months. For property or real estate assets, long-term is when your holding period is at least 24 months. Apart from listed equity, the benefit of indexation is applicable to all long-term capital gains.
What Are The Benefits Of Indexation?
Before we head to the benefits of indexation, let’s understand one thing clearly - When it comes to mutual funds, only debt mutual funds enjoy indexation benefits and not equity mutual funds.
- Indexation benefits on debt funds allow investors to earn high profits as the tax liability is low. It further encourages people to make investments in mutual funds. But how does that help you? Indexation is used to adjust an investment's purchase price to show the impact of inflation on it. A higher purchase price indicates lower income, indicating a lower tax. You will be able to lower your long-term capital gains with the help of indexation, lowering your taxable income.
- Indexation gives the opportunity to investors to increase an asset's purchase price. It helps lower the risk of the cost that can be caused by inflation. (The inflation rate that can be used for indexation can be derived from the Cost Inflation Index (CII) of the government. The values in the index are calculated by the central government and are updated on the website of the income tax department).
- Indexation benefits in debt funds translate to high returns on investments. It allows only the tax on LTCG gains to be adjusted, without impacting the absolute gains.
- When we compare it to other investment options such as fixed deposits, indexation in mutual funds brings stability, as it lowers LTCG liability for investors. This makes it a much more attractive investment option.
In The End…
Indexation helps you lower your taxes and earn higher returns on your investments. It is essential to learn about capital gain indexation to know how it can act in your favor and help you choose the right investment instrument. We hope this article helps you understand all about capital gain indexation, how it works and what benefits it provides to your debt mutual funds.
If you wish to learn more about other topics such as Capital Gains Taxation or Cost Inflation Index, you can click on the words, as we have written detailed blogs on them. If you wish to learn more about mutual funds and types of mutual funds, including Equity Mutual Funds, Debt Mutual Funds, Hybrid Mutual Funds, ELSS funds, and other types of investment instruments, such as Fixed Deposits, Digital Gold, and Smart Deposits, head over to our Blogs section.
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