Indexation is a tax benefit that adjusts the purchase cost of a long-term investment upward for inflation — reducing the taxable gain and thereby lowering the capital gains tax owed.
The government publishes a Cost Inflation Index (CII) annually. When you sell a long-term investment, you can multiply your original purchase price by (CII of sale year ÷ CII of purchase year) to get the 'indexed cost.' The taxable gain is calculated on this inflation-adjusted cost rather than the original purchase price. Indexation benefit was available on debt mutual funds held for more than 2 years for investments made before April 1, 2023. After that date, new debt fund investments no longer qualify for indexation.
Say you invested ₹1,00,000 in a debt fund in 2018 and sold for ₹1,60,000 in 2023 (60% absolute return). Without indexation, your taxable gain = ₹60,000. With indexation: your ₹1,00,000 purchase price is adjusted for inflation (say, 30% over 5 years) to ₹1,30,000 indexed cost. Now taxable gain = ₹1,60,000 − ₹1,30,000 = ₹30,000. You pay 20% on ₹30,000 = ₹6,000 instead of ₹12,000. Indexation essentially halves your tax by recognising that inflation has reduced the real value of your gain.
Government's Cost Inflation Index (CII) is published yearly by CBDT.
Indexed cost = Actual purchase price × (CII in year of sale ÷ CII in year of purchase).
Taxable LTCG = Sale price − Indexed cost.
Applicable for debt fund investments made before April 1, 2023, held for 2+ years.
Not applicable for equity fund investments (their LTCG tax rate is flat 12.5% without indexation).
Purchased debt fund in FY2018–19 at ₹1,00,000. CII 2018–19: 280. Sold in FY2023–24 at ₹1,45,000. CII 2023–24: 348. Indexed cost = ₹1,00,000 × (348 ÷ 280) = ₹1,24,286. Taxable LTCG = ₹1,45,000 − ₹1,24,286 = ₹20,714. Tax at 20% = ₹4,143. Without indexation (slab rate, say 30%): ₹45,000 × 30% = ₹13,500 tax — 3x more.