Budget 2025: Why indexation must be restored for fair capital gains taxation

Indexation is a crucial tax mechanism in India that adjusts the purchase price of an asset for inflation when calculating long-term capital gains (LTCG) tax. This ensures that taxpayers are taxed only on real profits, preventing inflated gains due to rising prices from increasing tax burdens unfairly. This is especially important in real estate, where inflation-driven price appreciation can distort tax liabilities.

The Cost Inflation Index (CII), published annually by the government, measures inflation and allows taxpayers to adjust an asset’s purchase price to reflect inflation, thereby reducing taxable gains. This adjustment ensures fair taxation based on actual value appreciation rather than nominal price increases.

Why Indexation is important

The indexed cost of acquisition is calculated using the formula:

Indexed Cost of Acquisition = (Original Purchase Price × CII of Sale Year) ÷ CII of Purchase Year

For properties acquired before April 1, 2001, the base year is set as April 1, 2001, with a CII of 100. This helps taxpayers determine a property’s fair market value as of that date and apply indexation accordingly.

Indexation- advantages

(i) Fair Taxation: Ensures that only real, inflation-adjusted capital gains are taxed.

(ii) Inflation Protection: Shields taxpayers from excessive tax burdens caused by inflationary price increases.

(iii) Encourages Long-Term Investment: Makes asset retention financially viable, reducing speculative trading.

(iv) Boosts Economic Growth: Promotes a tax-friendly investment climate, attracting both domestic and foreign investors.

(v) Simplifies Taxation: Uniform indexation calculations boost transparency and ease compliance.

(vi) Reduces Economic Disparities: Provides relief to middle-income investors and long-term asset holders.

Budget 2024: Unintended consequences of indexation elimination

Budget 2024 introduced a change by eliminating indexation benefits for LTCG on property sales for assets acquired after July 23, 2024. Taxpayers were given two choices:

(i) 12.5% LTCG tax without indexation

(ii) 20% LTCG tax with indexation (only for pre-2024 acquisitions)

Fallout of elimination of Indexation

(i) Heavier Tax Burdens: Taxable gains surged without indexation, leading to higher tax liabilities for property sellers.

(ii) Declining Real Estate Investment: Real estate lost appeal compared to tax-efficient alternatives like equities and bonds.

(iii) Market Slowdown: Reduced transaction volumes weakened liquidity in the real estate sector.

(iv) Increase in Unreported Transactions: To evade higher taxes, some sellers resorted to cash deals, undermining tax compliance.

(v) Loss of Set-Off Benefits: Without indexation, taxpayers lost opportunities to offset long-term capital losses against gains, limiting tax-saving avenues.

Illustration: Cost of eliminating Indexation

Consider a taxpayer who sells a residential apartment for ₹50,00,000 on November 1, 2024. The property was originally purchased on May 1, 2000, with a fair market value of Rs15,00,000 as of April 1, 2001. Without indexation, the taxable capital gain appears significantly inflated.

This plainly illustrates how the removal of indexation significantly inflated tax liability, punishing property sellers.

Backlash and course correction in Budget 2025

The elimination of indexation triggered widespread criticism from taxpayers, industry leaders, and tax experts regarding the disproportionate burdening of long-term property holders and threatened market stability. 

Recognising these concerns, the Government amended Section 112 of the Income Tax Act, 1961, through the Finance Bill 2024, reinstating indexation benefits for properties acquired before July 23, 2024. The revised options are now:

(i) 20% LTCG tax with indexation

(ii) 12.5% LTCG tax without indexation

This policy correction was a necessary step to restore investor confidence and align taxation with economic growth objectives.

Illustration: Tax-Saving Impact of Indexation

A property purchased in the financial year 2002-03 for ₹25,00,000 and sold in the financial year 2023-24 for ₹1,00,00,000 highlights the value of indexation:

While the tax rate without indexation appears lower, the taxable gain is significantly higher, leading to a 172% increase in tax liability.

Compelling reasons for reinstating indexation

(i) Restoring Market Confidence: The uncertainty caused by its removal disrupted investment planning; reinstating it reassures investors and stabilises the market.

(ii) Ensuring Fair Taxation: Taxpayers should not bear inflated tax burdens due to rising prices. Indexation ensures only real gains are taxed.

(iii) Enhancing Real Estate Investment: A stable tax structure makes real estate an attractive long-term investment.

(iv) Promoting Economic Growth: Investor-friendly taxation fosters long-term financial stability and economic expansion.

(v) Improving Compliance: Taxpayers are more likely to report transactions accurately when tax burdens are reasonable, reducing black-market dealings.

Conclusion

The elimination and subsequent reinstatement of indexation in India’s tax system highlight the importance of aligning fiscal policy with investor confidence. While the initial move aimed at simplifying taxation, it inadvertently created significant difficulties for property investors. The reinstatement of indexation through the amendment of Section 112 of the Income Tax Act represents a necessary course correction to ensure fair and growth-oriented taxation.

As India moves forward with economic reforms, consistency and transparency in tax policies will be crucial. A stable and investor-friendly taxation framework will encourage long-term investments, drive economic growth, and create a more equitable financial environment for all stakeholders.

(The author is Partner, Shardul Amarchand Mangaldas & Co)