Indexation method is used to compute tax amount when you sell debt mutual funds Long Term Capital gains are applied on the sale of debt mutual funds . This is applicable to long-term capital gains on debt mutual funds that have been held for 36 months and more
Let us understand it with a simple example.
Let us assume you ‘ve purchased Debt Mutual Funds of Rs10000/- in 2011-12 and sold in 2015-2016 for Rs 15000. If there was no indexation, you will have to pay LTCG tax on entire Rs5000 profit (15000-10000)
With Indexation, your cost price is adjusted as per inflation.
Inflation-adjusted cost price = Actual Cost Price* (CII of the year of sale/CII for the year of purchase)
Inflation adjusted Cost price= 10,000*(254/200)= Rs12,700
Therefore LTCG tax is applicable on Rs 2300 (15,000-12,700)
The higher the holding period , the more benefits indexation will have. Long-term capital gains tax on debt funds can come down from 20% to 5-7%. When you invest for more than 5 years in debt funds.