Indexation means adjusting or inflating the cost of acquisition of an asset over a period of time in order to bring it to current prices. This is done after taking into consideration the inflation rate, by using a Price Index which is adjusted for inflation at the time of purchase of an asset as well as at the time of its sale.
Mutual fund investments generate capital gains which can either be Short Term or Long Term in nature, depending on the holding period. Different funds are taxed differently. Indexation benefit is available only for Long Term capital gains (36 months or more) realized in Debt mutual funds.
A Cost of Inflation Index (CII) is used for adjusting the purchase price. CII is notified by the Ministry of Finance for every Financial Year.
CII of Sell Year/CII of Purchase year x Original Purchase Price
Benefits of Indexation are:
1. Indexation in debt funds provides investors with an opportunity to earn better returns.
2. It lowers the tax burden by adjusting the cost of acquisition.
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