What is it?
When you buy an asset and sell it after a few years at a higher price, it’s possible that its value goes up. But, even a rise in inflation could contribute to this price rise. The profit figure increases due to inflation, but more profits mean more taxes. Indexation helps you escape the tax you may have to pay on the inflated figure.
How does it help?
Indexation is a benefit that the Indian tax laws provide you to inflate your cost price to account for inflation—as measured by the Cost Inflation Index (CII) that the government updates every year—for the years you’ve held the asset. Your profits get reduced, only on paper, and so does your tax liability.
How does it work?
Let’s assume you bought an asset worth Rs50,000 in 2006-07 when the CII was at 519 and you sold it in 2008-09 at Rs60,000 when CII was at 582. As per the CII calculation, your cost price gets inflated to Rs56,069 (50,000x582/519). Hence, instead of paying tax on your actual gains of Rs10,000, you pay tax on only Rs3,931 (Rs60,000-Rs56,069).
Show me the money
Double indexation fixed maturity plans (FMP)—a popular mutual fund—offer you decent returns with such tax benefits. Typically, their tenures are short (13-15 months) but cover two accounting year-ends to provide two jumps at cost price. Such FMPs hit the market usually between January and March every year.