The formula for indexation in finance is used to adjust the cost of an investment for inflation. The formula is as follows:
Indexed Cost = Original Cost * (Cost Inflation Index of the year of sale / Cost Inflation Index of the year of purchase)
Where:
- Original Cost: is the cost of the investment in the year of purchase.
- Cost Inflation Index of the year of sale: is the cost inflation index of the financial year in which the investment is sold and the same is notified by Central Government alongwith analysis.
- Cost Inflation Index of the year of purchase: is the cost inflation index of the financial year in which the investment is purchased.
The cost inflation index is a measure of inflation and is published by the Income Tax Department of India. The index is used to adjust the cost of an investment for inflation, so as to arrive at its real value. The indexed cost is then used to calculate the long-term capital gains on the sale of the investment, which is taxed at a lower rate than the normal income tax rate.
For example, if a property purchased in Oct 2016 for Rs 10 lakh were to be sold in year July 2019 for Rs 20 lakh. Then
Indexed cost = (289/264) x 1000000 = Rs 1094697
And capital gains = (2000000 - 1094697) = Rs 905303
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