It has recently come to my notice that capital gains and indexation are two aspects of personal finance that many investors do not have a clear idea about. I was speaking to one of my friends the other day and he told me that he leaves such things for his CA to worry about. While, you can obviously take help of a CA to decide on how to deal with your taxes, it is important for every investor to understand these, especially in the context of debt instruments.
Let me start with capital gains first. We buy assets, physical or financial at a given price. For example the apartment that I bought in Chennai, cost me about 35 lacs in 2003. You may be doing a monthly SIP of 10,000 Rs in one MF scheme regularly. When we sell the asset at a later date at a higher price, the gain made out of such a transaction is termed as the Capital gain. In other words, Capital gain is the difference between the sale price and the acquisition price. Of course, if you are selling your asset at a lower price then there would be a capital loss. This is normally relevant for depreciating assets such as a car, which will fetch a lower value normally when you sell it after a few years.
Capital gains are part of our income and hence they need to be taxed. For the purpose of taxation these are classified as Short term or Long term. Depending on the asset, if you sell it within a defined time period the Capital gain is categorized as short term. Anything beyond this period will be treated as Long term capital gains. This distinction is very important from a taxation perspective. For example in the asset class equity, if the sale of the asset is within one year of acquiring it then it will fall under STCG. This will then be taxed at a rate of 15 %. So if I buy 500 shares of TCS at 2000 Rs and sell them within 6 months at 3000 Rs, my STCG will be 5 lacs and I will need to pay a tax of 75000 Rs in the year of sale.
Now for equities the Long term capital gain is applicable after one year and LTCG is currently not taxed. So in the same example as above if my holding period of the 500 TCS shares was more than one year, my LTCG will be 5 lacs but I will not be paying any taxes on it. This is true for any equity based asset such as Equity MF or a Balanced MF where the equity holding is more than 65 %.
It would be nice if LTCG for other assets were like equity but it is unfortunately not so. For Real estate and Debt instruments the LTCG applies only after 3 years. So if you invest in a debt MF today and redeem it in less than 3 years, the gain you make will be STCG and get added to your income. Also, unlike Equity the LTCG is not exempt from tax. However, recognizing the fact that inflation will have an impact on dampening the gain, a concept of indexation is used to calculate LTCG. The way this works is explained below:-
- Cost Inflation Index of the year 1981-1982 is taken as 100. Based on inflation from that point the index is revised every year. The current index for 2015-16 is announced at 1081.
- What this really means is an asset bought in 1981 needs to be indexed at around 10.81 times, in order to counter the effect of inflation, the asset cost in 1981 needs to be multiplied by 10.81 to get a fair value of cost in 2015.
- The LTCG can now be calculated with this indexed acquisition cost figure.
- For example I purchased my flat in Chennai for 35 lacs in 2003-2004 when the Cost Inflation Index was 463. If I want to sell it in 2015, when the Cost Inflation Index is 1081, the indexed purchase cost will need to be calculated by using the formula 1081/463 x 35 lacs. So the indexed cost will come out to be 81.7 lacs.
- So if I sell my flat for 1 crore today, the LTCG will be 18.3 lacs.
- This then will be taxed at 20 % in the relevant year of sale.
How does indexation help in debt investments and how are things changing on that front? I will try to address this in the next post.