Tax loss harvesting is the process of selling your investments to offset a capital gains tax liability. Investors can legally reduce their tax liability from capital gains by exploiting the recent losses in the securities market. This strategy is usually implemented near the end of the financial year but, can be exercised at any point of time in the tax year. With this strategy, the investor is allowed a credit when an investment with an unrealized loss is sold. This credit is allowed to be set off against gains from other investments in the portfolio. Let’s first understand how investments are taxed.
Understanding Holding Periods
Classification
Equity Investments – Listed Stocks & Equity Mutual Funds
All listed stocks and mutual funds that invest 65% or more in equity shares of listed companies are categorized are equity investments. All equity investments that are sold after holding period of 1 year are categorized as long term holding and those held for less than 1 year are short term holding.
Non-Equity Mutual Funds
All non-equity mutual funds which include debt funds, gold funds, fund of funds and international funds are categorized in a group. Investments held for less than 3 year are categorized as long term holding and those held for less than 3 year are categorized as short term holding.
Understanding Capital Gains for Tax Loss Harvesting
Gains/losses are defined on the bases of holding period. Gains/losses arising for investments held for short term are known as short term capital gains/losses (STCG/STGL) and gains/losses arising for investments held for long term are known as long term capital gains/losses (LTCG/LTGL).
Understanding STCG & LTCG Taxation
| Gain | Stocks/Equity MF | Non – Equity Investments |
| STCG | 15% | Individual Tax Slab |
| LTCG | 10%, no tax up-to 1 Lakh | 20% with Indexation |
How does Tax Loss Harvesting Work?
The income tax department says, “LTCL cannot be set off against any income other than income from LTCG. However, SHTL can be set off against LTCG or SHTG”. Let us look how you can take advantage of tax loss harvesting using a few examples;
Case 1: Mr. A had invested ₹ 15 Lakh in an Equity Index Fund in March 2016, and sold it in March 2020 for ₹ 18.80 Lakh.
| Details | Amount |
| March 2016 – Investment | ₹ 15,00,000 |
| March 2020 – Redemption | ₹ 18,80,000 |
| Long Term Capital Gain | ₹ 3,80,000 |
| Less Exemption Under Sec 112A | ₹ 1,00,000 |
| Taxable Long Term Capital Gain | ₹ 2,80,000 |
| Tax @ 10% | ₹ 28,000 |
Normally, the investor would end up paying a LTCG tax of ₹ 28,000. But he could reduce this tax payment if he had a notional loss in his portfolio and realized it. He had also made an investment of ₹ 10,00,000 small cap mutual funds in Jan 2018 which has now become ₹ 7,19,000, having a notional loss of ₹ 2,81,000. Tax loss harvesting would be the process of selling this investment so that the loss can be set off from the gains of his other profitable investments.
| Date of Investment | Transaction Type | Amount |
| Jan 2018 | Purchase | ₹ 10,00,000 |
| March 2020 | Redemption | ₹ 7,19,000 |
| Long Term Capital Loss | ₹ 2,81,000 |
| Set of Capital Gains Against Losses | Amount |
| Long Term Capital Gain | ₹ 3,80,000 |
| Less Long Term Capital Loss | ₹ 2,81,000 |
| Taxable Long Term Capital Gain | ₹ 99,000 |
| Less Exemption Under Sec 112A | ₹ 1,00,000 |
| Taxable Long Term Capital Gain | Nil |
This entire exercise of booking notional losses to help you set-off against gains in your portfolio is called Tax Loss Harvesting.
Case 2: Mr. B made an investment of ₹ 10,00,000 in small cap mutual funds in Sept 2019 which has now become ₹ 7,19,000, having a notional loss of ₹ 2,81,000.
Unlike Mr. A, Mr. B doesn’t have any gains from his investments. In such a scenario, the income tax department allows an assessee to carry forward short term and long term capital losses for the next 8 financial years. Mr. B can therefore realize his short term capital losses this year and set them off against short term or long term gains in the next 8 financial year. For this, it would require that he sell his investments and reinvest the proceeds.
Case 3: Mr. C had invested ₹ 15 Lakh in an equity mutual fund in March 2016, and sold it in March 2020 for ₹ 13.80 Lakh.
He had made an investment of ₹ 10,00,000 in a debt mutual funds in Sept 2017 which has now become ₹ 12,19,000, having a notional STCG of ₹ 2,19,000.
According to income tax rules, although he has a LTCL of ₹ 1,20,000 he is not allowed to set this off against the STCG of ₹ 2,19,000. He can however, carry forward such LTCL for the next 8 financial years and set-off against any possible LTCG in future.
Important Points to Remember
- LTCL cannot be set off against any income other than income from LTCG. However, SHTL can be set off against LTCG or SHTG.
- There is no guarantee that you will be able to recover the losses you realize.
- It only ensures that you sell some of your investments to reduce taxes.
- It is important to carefully evaluate the tax liability. If you don’t understand, take help of a financial planner or a CA understand how to avail this benefit while filing your taxes.
- There is considerable re-investment risk; the market might rally after you sell and negate the benefit of tax harvesting before your reinvest the proceeds.
- This is beneficial only as a tax saving tool and should not be the sole criteria for your investments. Looking at your larger investment strategy and aligning it with your risk profile and goals should be given paramount importance.
Get a FREE consultation call with our fee only financial planner on how you can use these strategies for your portfolio.
