InvestorQ : How does indexation work here with respect to debt funds?
NISHA Nayak made post

How does indexation work here with respect to debt funds?

3 years ago

As you are aware indexation benefit is not available for equity funds because they get a blanket exemption of Rs.1 lakh for each financial year and only profits above that limit are actually taxed. Indexation is a prudent way to prevent draining of your debt fund returns by way of taxes. It helps you to inflate the purchase price of the debt mutual funds. In this way you can lower your tax liability. When it comes to debt funds, it’s important for you to understand two concepts i.e. inflation and capital gains.

Let us revise our concept of capital briefly before getting down to calculation of indexed capital gains in the case of debt fund investments. It helps you to reduce your taxable capital gains by inflating the cost of acquisition using the CII.

Capital Gains refer to an increase in the value of an investment over a specific time frame. If the NAV of the debt fund at the time of purchase was Rs.45 and after 5 years you sell the debt fund units at Rs.73, then the capital gains will be Rs.28 per unit. However, you don’t have to pay tax on the entire capital gains of Rs.28 but only on the indexed capital gains. Let us look at that with an illustration. Remember, in case of debt funds, the investor has to pay flat tax at 20% on the quantum of indexed capital gains. Which of the options should you choose? Let us look at this decision from the point of view of an investor who has booked long term capital gains on debt funds. Remember that debt funds being non-equity funds is treated as long term capital gains if it is held for a period of more than 3 years.

Gains from the sale of debt mutual fund units are classified as capital gains that allow the investor to use indexation while computing tax on them. This is applicable on long-term capital gains on investments that have been held for 3 years and more.