If you have bought a house, say, for Rs 1,000,000, expecting the investment to yield rich returns after 20 years, think again. If the price of your property doesn’t grow by at least the current rate of inflation (5.45 per cent per annum), the value of your initial investment will erode.

A bottle of water that you can now buy for Rs 10 will cost Rs 28.90 after 20 years if inflation persists at the current rate of 5.45 per cent! Similarly, your cost of acquiring the house (Rs 10 lakh now) will be equivalent to Rs 28.90 lakh after 20 years. Anything over and above Rs 28.90 lakh that you get by selling the house after 20 years will be your capital gain in real terms.

Inflation eats into all investments. Hence, the cost of inflation must be taken into account while considering any investment and its subsequent sale.

Moreover, you will have to pay a capital gains tax on the sale of an asset such as a house and jewellery.

At present, one doesn’t have to pay any long-term capital gains tax on investments in stocks and diversified equity schemes of mutual funds, provided the stocks (and mutual fund units) are held for more than 12 months and securities transaction tax is paid.

For all other assets, you will have to pay capital gains tax.

You would, therefore, want to include the inflation effect on the acquisition cost of the property to calculate capital gains and the tax to be paid.

Under the current taxation rules, cost of acquisition of an asset can be indexed to the rate of inflation during the period of sale. But this benefit is available only for calculating long-term capital gains and the tax thereon.

If one avails of the indexation benefit to inflate one’s cost of acquisition, the tax rate will be 20 per cent.

However, one can pay long-term capital gains tax without adjusting the acquisition cost with the inflation index. The rate in this case is 10 per cent.

The question that now arises is when to use the indexation benefit.

Cost indexation at times reduces the tax liability even if the rate is 20 per cent.

An asset (other than stocks) is considered to be long term under the current tax laws if it is held for more than 36 months from the date of purchase.

If the asset is a house, one can save capital gains tax by investing in another house. If the property is your residence, you can claim long-term capital gains tax exemption by investing in another house within three years.

But if the house that you are selling is not your residence — a property that you have put on rent — you will have to invest the money within six months.

Let us now see how the cost of acquisition is indexed to inflation.

For every financial year, the Reserve Bank of India and the income tax department announce an inflation index (see table). Suppose, you bought a house in 1981 for Rs 5 lakh and sold it in 2001 for Rs 25 lakh.

The inflation indices for these years are 100 and 426, respectively. So, your cost of acquisition of the property at 2001 prices (though you actually bought it in 1981) will be Rs 500,000 x 426/100 or Rs 21.3 lakh. Your capital gains will be Rs 25 lakh minus Rs 21.3 lakh or Rs 3.7 lakh. Your long-term capital gains tax liability will be 20 per cent of Rs 3.7 lakh or Rs 74,000.

Now consider what will be your long-term capital gains tax liability if you don’t go for the cost indexation. Your capital gain will be the difference between the sale price and the price you paid to buy the house. It is Rs 20 lakh. The tax liability will be 10 per cent of Rs 20 lakh or Rs 2 lakh.

It is now clear that cost indexation can reduce the capital gains tax burden to a large extent — you save Rs 1.26 lakh.

If you hold an asset for a long period, indexation ought to help you lower the capital gains tax burden.