Use high inflation to bring down your capital gains tax

If petrol at Rs 58 a litre and onions at Rs 45 a kg are breaking your back, heres some cold comfort. The high prices could actually help bring down the tax on your long-term capital gains. The taxman understands that inflation is not only burning a hole in your wallet but also destroying the value of your investments over time. So he allows taxpayers to adjust for inflation by opting for indexation in case of long-term capital gains.

If you sell an assetproperty, gold funds and debt-oriented fundsat a profit, your gains are taxable. If they are short-term capital gains, they are clubbed with your income for the year and taxed at normal rates. But if the holding period is longer, the gains are treated as long-term capital gains and taxed at a lower rate. The investor has the choice to pay a flat 10% tax on the capital gain or 20% after indexation. In times of high inflation, the tax after indexation can be much lower than the flat 10%, says Delhi-based chartered accountant Surya Bhatia.

The taxman has different minimum holding periods for each asset. For debt funds (including fixed maturity plans), debt-oriented hybrid funds (including monthly income plans) and gold exchange-traded funds, this is one year. But for real estate and bullion, the minimum holding period is three years.

Investors in debt funds (especially FMPs) can use the indexation benefit to the hilt. If you had invested in a debt fund at the fag end of a financial year (say, in March 2008) and redeem the investment 13 months later in April 2011, you will be able to avail of indexation benefit of four f! inancial years. In times of high inflation, this can reduce the tax liability to zero.

However, if you exit in February 2011, you will get the indexation benefit of only three years. As the above calculation shows, this may not result in a lower tax liability compared with that in the flat 10% option. So, keep an eye on the calendar when you sell your debt mutual funds or other assets that are liable for capital gains tax.