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Cost Inflation Index : A tax saving formula

Suppose, in June 2005 you bought a property worth Rs.20 lakhs. In Jan 2015, you sold it for Rs.70 lakhs. Your Gains = Rs.50 lakhs.

Do you have to pay tax on this profit of Rs.50 lakhs from the sale of your property?

No. Your "taxable" gains are much lower, thanks to the concept of Cost Inflation Index.

What is Cost Inflation Index (CII)?
In plain and simple terms, CII is
- the benefit extended by the Govt. to the taxpayers
- for the rise in prices due to inflation.

Increase in the price of your property comprises two components: 
(a) escalation on account of inflation in the economy and 
(b) actual profit.

By permitting you to apply cost inflation index, termed as indexation benefit, the Govt. is compensating you for the increase in price because of inflation; and only the actual profit out of your total gains is taxed.

How is this Cost Inflation Index calculated?
Financial Year (FY) 1981-82 has been fixed as the base year, with CII as 100. Thereafter, CII for each FY is calculated, based on the Consumer Price Index for urban non-manual employees, as the measure of inflation.

The formula that the Govt uses, for calculating yearly CII, is as under :

CII for the year = CII for the previous year + 75% of the Consumer Price Index

In other words, 75 percent of the average rise in prices in the previous year, is being compensated for, in the Cost Inflation Index.

Based on the foregoing, the Cost Inflation Index from FY 1981-82 up to the current FY i.e. 2015-16, as notified by the Govt., is given at the end of this article.

save-tax-with-cost-inflation-index
Cost Inflation Index helps you to cut down your tax liability on sale of assets

How does the concept of CII work in your favour?
As mentioned earlier, your "taxable" gains are not the actual gains, but the "indexed" capital gains; which is calculated as under:

Actual Sale Price - Indexed Cost Price = Indexed Capital Gains
where:
Indexed Cost Price = (Actual Cost Price * CII in the year of sale) / CII in the year of purchase

Thus, in your case
Indexed Cost Price = (20 * 1024) / 497 = Rs.41 lakhs
[See table below: CII in 2014-15 is 1024 and CII in 2005-06 is 497]

Indexed Capital Gains = 70 - 41 = Rs.29 lakhs

In other words, your taxable gains is only Rs.29 lakhs vis-a-vis your actual gains of Rs.50 lakhs.

So, what is the tax liability now?
Our normal income is taxed at Nil, 10%, 20% or 30%, based on our income slab.

However, capital gains are taxed differently.

In the above case, flat 20% tax is applied on the indexed capital gains.

Thus, your tax liability would be Rs.5.80 lakhs [= 20% * 29 lakhs]. 

By the way, you can save even this reduced tax liability if you follow the provision of section 54 of the Income Tax Act.

[Note: For simplicity purposes, I have excluded (a) cost incurred in connection with the sale, (b) the 'cost of improvement', which is also indexed and reduced from the Sale price to arrive at the net capital gains and (c) education cess and surcharge, if applicable in calculating the tax liability.]

For those interested, this is covered under section 48 of the Income Tax Act.

Can I claim the benefit of Cost Inflation on all property sales?
No.

Only the properties held for more than three years (termed as Long Term Capital Gains) are eligible for the benefit of CII indexation and 20% tax rate on the same.

Gains from properties held for less than three years (termed as Short Term Capital Gains) are to be added to your total income for the year and taxed as per the income tax slab rates.

Apart from property, where can I claim the benefit of Cost Inflation?
In addition to real estate, other capital assets that you can own include gold, shares, mutual funds, bonds, debentures, FDs, etc. Some of these enjoy the benefit of cost indexation and some don't, as detailed below:

Real estate, Gold, Gold ETF : Taxed @20% with indexation benefit (if held for more than 3 years)

Mutual funds (except equity and balanced funds)Taxed @20% with indexation benefit (if held for more than 3 years)

Company Bonds and Debentures : 20% with indexation or 10% without indexation, whichever is lower (if held for more than 1 year)

Tax-free bonds : No indexation benefit. Taxed @10% (if held for more than 1 year)

Shares, Equity and Balanced Mutual Funds : Not required as long term capital gains are anyway tax free (if held for more than 1 year)

Fixed Deposits, Post Office Schemes, etc. : No indexation benefit



COST INFLATION INDEX
Financial Year
CII
Before 1/4/1981
100
1981-82
100
1982-83
109
1983-84
116
1984-85
125
1985-86
133
1986-87
140
1987-88
150
1988-89
161
1989-90
172
1990-91
182
1991-92
199
1992-93
223
1993-94
244
1994-95
259
1995-96
281
1996-97
305
1997-98
331
1998-99
351
1999-00
389
2000-01
406
2001-02
426
2002-03
447
2003-04
463
2004-05
480
2005-06
497
2006-07
519
2007-08
551
2008-09
582
2009-10
632
2010-11
711
2011-12
785
2012-13
852
2013-14
939
2014-15
1024
2015-16
1081

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