How are capital gains calculated with indexation?

Capital gains refer to an increase in the value of an investment over a specific timeframe. If the NAV of a debt fund was Rs.10 last year and today it stands at Rs.11, therefore, the value of your investment has appreciated, and this is called capital gains. Here, your investment would yield a capital gain of Rs. 1 per unit if you redeem the fund. In other words, a capital gain is a difference between the purchase price and the sale price of a debt fund. However, in case the gains are long-term in nature (holding period of more than 3 years), capital gains are arrived after indexing the purchase price of the investment.
The long-term capital gains on debt funds are taxable at 20% after allowing the benefit of indexation.
With the help of indexation, you will be able to lower your long-term capital gains on debt funds and thus bring down your taxable income. Indexation is the reason why debt funds are considered an excellent fixed-income investment option when compared to fixed deposits. Indexation makes the investment in debt funds much attractive.
Example - Let's say you invested in a debt fund in July 2016. Your investment amount was Rs.10,000 and you bought the units at a NAV of Rs.10. 6 years later, you redeemed your investments in September 2022 at a NAV of Rs.20. Hence, when you sold your investments, the value of your investments was Rs.20,000. Therefore, you made capital gains worth Rs.10,000.
However, you need not pay tax on this entire gain amount of Rs.10,000 as your holding period was more than 3 years and thus you will get the benefit of indexation to reduce the value of your long-term capital gains. To arrive at the Indexed Cost of Acquisition, you have to use the following formula:
Indexed Cost of Acquisition = Original cost of acquisition * (CII of the year of sale/CII of year of purchase)
In the example mentioned above, the indexed cost of acquisition will be Rs. 12,538, i.e., (10,000 * 331/264).
Hence, instead of Rs.10,000, your capital gains will now be Rs.7,462, i.e. (Rs.20,000 - Rs.12,538).
Using indexation, you have managed to pay tax on only Rs.7,462 instead of Rs 10,000. The benefit of indexation works best when your holding period is longer. This is how indexation benefit helps you to save tax on long-term capital gains from debt mutual funds and enhance your returns.