When you sell mutual fund units, you have to pay tax on the profit. This profit is known as capital gains and the tax paid on such profit is known as capital gains tax. For example, if you purchase mutual fund units for Rs 5000 and sell at Rs 6000, you will have to pay tax on the gain of Rs 1000. However, the rate at which this capital gains tax is levied depends on the period of holding and the type of the fund.

Indexation comes into play while calculating the net tax liability on capital gains. The indexation provision under the Income Tax Act helps in reducing the profit gap between the purchase price and the sale price on account of inflation, which in turn reduces the net tax payable.

With indexation, you can inflate the purchase price by a government-notified inflation factor, which is known as the Cost Inflation Index. When the purchase price increases, the total profit comes down, which also reduces the capital gain tax liability. But there is a catch. To be eligible for the indexation benefit, you need to invest in the growth option of the fund and remain invested for a minimum period of 3 years.

Let’s understand this with an example:

Suppose X purchased a mutual fund unit in October 2018 when its NAV was Rs 500 and redeemed in October 2023 when the NAV was Rs 800. As X remained invested for more than 3 years, he will be eligible for indexation benefit.

As per the Income Tax Department’s website, the CII for 2018-19 was 280. For the redemption year 2023-24, it is 348 (provisional).

For tax liability calculation, the purchase cost can be indexed up with reference to the CII in 2023-24 divided by the CII in 2018-19 i.e. 348/280xRs 500 = Rs 621. The tax liability here will be on the difference between the indexed-up purchase price and the sale price, which is Rs 800-Rs 621 = Rs 179.

Now that you have understood, how indexation is calculated, let’s understand which funds are eligible for indexation benefits.

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Which funds are eligible for indexation

As per Finance Act 2023, indexation benefit on debt mutual funds is no longer available. The Act says gains from the growth option of a debt mutual fund with less than 35% equity allocation will be taxed as Short Term Capital Gain (STGC), which is calculated at the marginal tax slab rate and doesn’t take into account the holding period.

For example, if you are in the 20% tax slab, the STGC will be 20% of gains plus cess and surcharge even if you hold the fund for more than 3 years.

However, there is no change in the taxation of equity mutual funds. But pure equity funds with more than 65% allocation in equity do not enjoy indexation benefits. If you remain invested in the growth option of an equity mutual fund for more than 12 months, you become eligible for Long Term Capital Gain (LTCG) tax, which is calculated at 10% plus cess and surcharge. In case the holding period is less than 12 months, then gains will be taxed at 15% plus cess and surcharge.

The Finance Act has, however, opened up the indexation advantage for some funds having more than 35% but less than 65% allocation to equity. There are some hybrid and multi-asset funds that allocate 35-65% in equity and may be eligible for the indexation benefit.

However, you should note that if any Hybrid or Multi-Asset fund has invested more than 65% in equity then it will be considered as an equity fund for tax purposes and become ineligible for indexation. Therefore, it is advisable to check with the AMC or a financial advisor whether the fund in which you are investing is eligible for indexation or not.

Disclaimer: The above content is for informational purposes only. Mutual Fund investments are subject to market risks. FE Money recommends consulting a SEBI-registered financial advisor before investing in mutual funds.