When you make a gain or profit on the sale of a non-inventory asset, you are required to pay tax on it, which is called the capital gains tax. The tax is levied on the profit realised on the purchased cost of the asset, provided the latter was lower.
Now, this is one component that can eat into your gains from an investment, and thus impact the overall return on it.
Now capital gains tax can be of two types, long-term capital gains tax and short-term capital gains tax, the latter being slightly higher. If one remains invested in an asset class for more than three years, it will qualify for long-term capital gains tax while if the asset is sold before three years, it would invite short-term capital gains tax. The long-term capital gains tax being lower, it makes a case for staying invested in an asset class for more than three years.
The current rate of long-term capital gains tax is 20 per cent, but the biggest benefit here is that it allows for indexation benefit. Indexation lets you to index your cost of purchase of the asset with the rate of inflation. Which means you can factor in the rate of inflation to bring your historic cost of purchase to today's value, which will raise the deemed cost of purchase of the asset and accordingly a lower return will be considered for the calculation of capital gains tax. Hence, you would often find mutual fund schemes are launched around March, which is the last month of a financial year, so that it can use the indexation benefit of that year while calculating long-term capital gains tax.
Now besides equity investment, others such as investment in gold, real estate and even several debt instruments may fall in this category as they are usually held for longer periods. Accordingly, in these cases the investor will have the benefit of using indexation for the purpose of calculating capital gains tax.
In the case of short-term capital gains tax, however, the tax is calculated on the basis of standard tax rate, which is the income-tax slab in which you fall. In such cases, profits from any investment is added to the annual income of the individual and are tax according to his/her tax bracket. So if you fall in the 30 per cent tax bracket, the post-tax profit on your debt fund investment or, say bank fixed deposit, will get reduced by as much in the final count.
It would be prudent to understand these tax dynamics as a little timing here and a little extra time there can save you a lot in terms of returns earned on an asset class.
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