Tax loss harvesting or tax harvesting is the process of selling stock or mutual fund units to reduce tax on capital gains. Invested in equity markets (stocks or mutual funds)? Do you know that you can save taxes on gains using tax harvesting? In this post, we will discuss the ins and outs of tax harvesting.
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How mutual funds or stocks are taxed?
Tax-loss harvesting is the process of booking losses you incurred on mutual funds or stocks to set off against the gains you made. To understand this first, let me introduce you to the concept of short term capital gains and long term capital gains. If you sell any mutual fund unit or stock within 1 year of purchasing it for a profit, you incur short term capital gain. Similarly, if you sell your equities for a profit after holding at least 1 year, then you incur long term capital gain. The same rule applies for short term or long term capital loss as well. Indian Income tax act, 1961 charges 15% tax on short term capital gain and 10% tax on long term capital gain on gain above Rs.1 lakh.
Setting off short term or long term capital losses:
Thankfully, Income Tax act also allows you some relief when you incur a capital loss. You can set off your long term or short term capital loss with your capital gains. As per the Income-tax act, you can set off your long term capital losses against long term capital gains (LTCG) only. However, if you incur short term capital loss, you can set off with either short term capital gain (STCG) or long term capital gain (LTCG). With this basic information on taxation, you can now understand the concept of tax loss harvesting. Let’s jump into our area of interest today: Tax harvesting!
Tax Loss Harvesting Stratrgey:
As discussed earlier, tax harvesting is the process of selling stocks or mutual funds for loss to set off against capital gains. Let us try to understand this better with an example:
Rakesh is an avid equity market investor and has achieved Rs. 1,50,000 long term capital gain and Rs. 50,000 short term capital gain. Handsome returns, eh? (Well any investor would like to showcase his profits on investments made, Rakesh is no exception 😂). However, he has unrealized capital losses as well. We will come to that part later. Let us first try to understand the taxes that Rakesh may have to shell out of his pocket.
Short term capital gains tax: Rs. 7,500 (15% on the gain of Rs. 50,000)
long term capital gain tax: Rs. 5,000 (10% on the gain over Rs. 1 lakh (1,50,000-1,00,000))
Total capital gains tax: Rs. 12,500
As said earlier, Rakesh is currently sitting at loss in some of his mutual funds or stocks which have underperformed. After our advice, he went through his portfolio and found out noted the following: Rakesh is in losses of over Rs. 40,000 in his long term stocks and over Rs. 20,000 loss in stocks that he is holding for short term. After learning about tax harvesting, Rakesh booked losses on both (he sold both stocks for a loss). In effect, he now has a short term capital loss of Rs. 20,000 and long term capital loss of Rs. 40,000. Now he can do the following math and quickly evaluate how much taxes he can save:
Setting off capital loss:
- Set off short term capital loss: Rakesh has Rs. 20,000 short term capital loss which he can set off either with the short term capital gain or short term capital gain. Since tax on STCG is 15%, he chooses to set off his short term capital loss against STCG first.
Set off: Short term capital gain: Rs. 50,000
Short term capital loss: Rs. 20,000
Net STCG: Rs. 30,000
Tax on STCG: Rs. 4,500 - Set off long term capital loss: Rakesh has Rs. 40,000 long term capital loss which he can set off against long term capital gains only. Rakesh does this set off which looks like below:
Set off: Long term capital gains: Rs. 1,50,000
Long term capital loss: Rs. 40,000
Net LTCG: Rs. 1,10,000
Tax on LTCG: Rs. 1,000 - Total capital gains tax before utilizing tax harvesting: Rs. 12,500 (Rs. 7,500 + Rs. 5,000)
Total capital gains tax after harvesting tax losses: Rs. 5,500 (Rs. 4,500 + Rs. 1,000)
Tax benefit by using tax harvesting: Rs. 7,500
Benefits of Harvesting Tax Loss:
Rakesh has made an intelligent saving on his outgoing income tax by just rejigging his portfolio. Remember that Rakesh can again buy the stocks or mutual funds that Rakesh sold for loss the next day itself if at all he believes in their recovery. Tax harvesting doesn’t require rigorous planning or too much technicality. Just some common sense and awareness about STCG and LTCG. That being said, please consult your investment advisor should you face any difficulty in doing this exercise. Going forward, every equity investor should review his portfolio before the end of the financial year and evaluate his capital gains or losses, and accordingly harvest them. Harvest is good for agriculture, likewise, the harvest is good for personal finance too!