When you invest in equity-yielding financial securities like stocks and mutual funds, you make money in the form of capital gains over a specific period. The realisation of these capital gains, i.e., their encashment, becomes a taxable entity as it adds to your income stream. Capital gains are taxed according to the duration of your participation in the fund and market.
But there is one way that the law provides to reduce the tax burden on your investment gains; it is called Tax-loss harvesting. So, let’s delve into the details of tax loss harvesting and its various technical processes.
In tax loss harvesting, you sell your stocks/fund units at a loss to reduce your tax liability on capital gains. It is a method to offset the capital gains made on equity against the capital loss suffered to pay a lesser tax. Let us break down the process further, starting with the latest amendments in the law about the taxability of capital gains.
Tax amendments by the government on capital gains
Earlier, long-term capital gains from selling equity stakes and stock assets were completely tax-free for investors. However, amendments brought in by the 2018 union budget changed that. It got capital gains on the sale of listed shares and investment funds under tax purview.
Under the new rules, starting from April 1, 2018, long-term capital gains (LTCGs) above Rs. 1 lakh came under the 10% tax limit without indexing benefits. Indexing is used to change the purchase price of an investment to reflect the effect of inflation on it. A higher purchase price translates into lower profits, which means substantially lower taxes.
Indexing allows you to reduce the return on capital in the long run by reducing taxable income. But the new amends made such indexing benefits impossible. By law, short-term capital gains (STCGs) are taxed at the rate of 15%.
As the taxation of capital gains on investments emerged, the law gave one option to investors for paying reduced taxes on such profits. This is where tax loss harvesting steps in - it can help you reduce the tax liability on both LTCG and STCG.
Tax loss harvesting
Tax loss harvesting is the method of trading financial security that undergoes a loss and helps you avoid some amounts of taxes, thus saving your money. By harvesting, i.e., realising losses, investors can offset their taxes on gains and income.
In tax loss harvesting, the shares must be withdrawn from the Demat account by a delivery sell transaction. You can purchase (or re-purchase) them the next day. The sold asset is substituted with a similar one, maintaining an optimal asset allocation and expected returns.
What does offsetting losses mean?
Offsetting in taxation processes means subtracting a capital loss from a capital gain and paying less tax. Simply put, the adjustment of losses against income or profit in a particular year is called set off.
For example, if you own two stocks and sell one at a profit and the other at a loss, you only pay capital gains tax on the difference between profit and loss. Losses not set off against income can be carried forward to subsequent years and used against income.
Usually, investors use tax loss harvesting for STCG because the tax rates on short-term capital gains are higher than long-term capital gains.
Realised versus unrealised gains (or losses)
A realised gain occurs when an investment is sold for a price higher than the buy price. Income from realised gains is subject to income tax. Depending on the time of holding, such profits are divided into short-term or long-term gains. Long-term gains are held for more than a year, while short-term gains are held for less than a year.
An unrealised gain is an increase in the value of investments that investors have not yet sold for money. On the other hand, an unrealised loss is a decrease in the value of an asset or investment that is held instead of its sale and loss realisation.
Example of tax loss harvesting
Suppose you earned Rs. 1 lakh in short-term capital gains this year. You will be taxed 15% or Rs. 15000 on this STCG. Assume that you currently have stocks holdings with an unrealised loss of Rs. 60,000. You can sell these stocks (and realise the loss) to reduce your net STCG to Rs 40,000
Realised gains – Realised loss = Net capital gain, i.e., Rs. 1,00,000 – Rs. 60,000 = Rs. 40,000.
As you realise the loss, you will have to pay 15% of Rs. 40,000, i.e., Rs. 6,000 as taxes. This will save you Rs. 9,000 in taxes. This method will let you harvest your losses and save on taxes – hence it is called tax-loss harvesting.
Mantras to remember while using tax loss harvesting
Now, you might wonder that your portfolio will reduce in size by realising the loss and selling the loss-making stocks. To counter this sale of stocks, you can place a simultaneous buy order of the same stocks or different stocks of a similar nature.
By using tax loss harvesting, you have realised the loss on the face. But with the simultaneous buy order, your portfolio will not get disturbed, and you will be able to save on taxes as well.
While setting off losses using tax-loss harvesting, you need to keep the following points in mind:
- You can only set off long-term capital loss against long-term capital gain. You cannot set off long-term capital losses against short-term capital gains.
- As an investor, you can set off short term capital loss against short term capital gain as well as long term capital gain.
Carry forward of losses
Unadjusted loss can still occur after making the necessary and permissible offset deals and adjustments. These unadjusted losses can be carried forward into future years to adjust for earnings. Different income origins have diverse rules regarding taking forward capital losses. You can move the loss forward for up to eight years after its assessment year.