You need to hold investments like Property, Gold, Non-equity oriented Mutual Funds like Debt funds for 3 years to be considered as (long term capital gain) LTCG; otherwise, it falls under STCG. Indexation factors in the inflation of your investment.
Let’s consider a debt mutual fund you bought in 2011 with 100000. These are considered LTCG only if the holding period is more than 3 years only.
Hypothetically, let’s say we sell this mutual fund at 300000 in 2015.
How will you find the LTCG and tax?
Previously, the long term capital gain was simply 3L-1L = 2L and the tax was flat 20% without indexation i.e. 20% of (3L-1L) = 40K. So 40K would go to tax.
Now you need to use https://www.incometaxindia.gov.in/charts%20%20tables/cost-inflation-index.htm to get the values of CII (The cost inflation index (CII) are fixed by Government of India in its official Gazette to measure inflation.)
- CII of the year of purchase = CII of the year of 2011 = 184
- CII of the year of sale = CII of the year of 2015 = 254
Inflation-adjusted buy value = Buy value * (CII of the year of sale)/(CII of the year of purchase) = 100000 * (254/184) = 138043.478
Now, long term capital gain with indexation = 3L – inflation adjusted buy value = 3L – 138043.478 = 161956.522
So, the tax will be = 20% of 161956.522 = 32391.3044 ~ 32391 INR. You can be saving 40000-32391 = 7609 INR from this new indexation method.