The current market crash has been very painful. Equity portfolios have taken deep cuts. During such times when we are so occupied with limiting losses in our equity portfolios, we might lose out on peculiar tax-saving opportunities that these times may throw up.
I am talking about tax-loss harvesting, where you can use losses from one capital asset to set off capital gains in the same or different asset class. And we know that there is no dearth of capital losses in the equity portfolios these days.
I have written about tax-loss harvesting before, but I wrote that primarily in the context of portfolio rebalancing and switching from regular plans to direct plans. The past few weeks have been difficult for equity investors. However, using the tax-loss harvesting, they might be able to reduce the tax outgo and perhaps assuage some pain.
In this post, let’s discuss set-off provisions and tax loss harvesting through which you can reduce your capital gains tax liability.
- What are the set-off provisions for capital gains and losses?
- What is Tax Loss Harvesting?
- How can you reduce capital gains tax liability using Tax-loss harvesting, especially during current times?
Set-off using Capital Losses
Short-term capital loss (STCL) from the sale of any capital asset can be used to set off:
- Short-term capital gains (STCG) from the sale of any capital asset
- Long-term capital gains (LTCG) from the sale of any capital asset.
Long-term capital loss (LTCL) from the sale of any capital asset can be used to set off:
- Long term capital gains from the sale of any capital asset.
As you can see, STCL can be used to set off both STCG and LTCG.
On the other hand, LTCL can be used to set off only LTCG.
You can use this set off across asset classes too.
For instance, you can use STCL from the sale of debt mutual funds to set off STCG from the sale of equity funds/shares/debt funds/gold/bonds/real estate etc.
You can use STCL from your stocks/equity funds to set off STCG or LTCG from debt mutual funds or other capital assets OR even STCG or LTCG on equities booked earlier in the year.
You can use LTCL from your stocks/equity funds to set off LTCG from the sale of debt mutual funds or other capital assets OR even LTCG on equities booked earlier in the year.
This way, you can bring down your capital gains tax liability.
Please understand I am talking about Realized gains or losses. Unrealized gains or losses have no meaning in this context.
What is Tax Loss Harvesting?
Given that the income tax department allows such adjustments, you can use this provision to save this save some tax on capital gains.
Sometimes, this will happen automatically. You will make a profit on a few sales and losses on others. You will pay tax only on the net gain.
However, there may be instances where you may selectively want to sell a losing asset (which is down from your purchase price) only to book losses. Such losses can be used to set-off capital gains during the financial year. This will bring down your capital gains tax liability. This tax optimization is known as tax-loss harvesting.
Do note there may not be a desire to dispose off such asset. You plan to buy it back after a few days. However, this sale and repurchase of the asset may help you save capital gains tax.
You may want to set off STCL against short term capital gains since STCG is typically taxed at a higher rate as compared to LTCG. Not necessary though.
What can you do in a market crash?
We have seen a very sharp equity market correction since Feb 28, 2020.
I believe all of us have stocks/equity mutual funds that are sitting on a loss.
You can book such losses and use it to set off your capital gains in debt mutual funds/bonds/gold and even property. You can always buy the stock/units back later.
Note that selling equity shares at a loss (and buying them back) will cause the cost price of the equity share to rise. Thus, when you sell this stock (eventually at a higher price), you will have to pay more tax.
Let’s consider an example. You bought ABC stock at Rs 300. You sell the stock after 3 months at Rs 200 at a loss of Rs 100. Thus, you have STCL of Rs 100 per share. You can use this loss to set off capital gain from the sale of any other capital asset.
Now, let’s say you buy the share back for Rs 200. After six months, you sell it for Rs 350. This will result in short term capital gain (STCG) of Rs 150 (350-200). This will be taxed at 15% (unless you figure out yet another tax harvesting opportunity). If you had held on the share (and not done that tax harvesting bit), you will have STCG of Rs 50 only (350-300). Therefore, you have increased your taxable capital gains on stock ABC.
However, STCG on sale of equity/equity fund units is taxed at 15%. If you used the STCL on equity sales to set off capital gains in an asset (let’s say STCG on debt mutual funds) that are taxed at a higher rate (say 30%, can be higher due to surcharge and cess), you would have saved quite a bit of tax.
Continuing with the same example, let’s say you had invested Rs 10 lacs in ABC stock (at Rs 300). You sold at Rs 200 (and booked a loss of 3.33 lacs). You used this loss to set off STCG of Rs 3.33 lacs in debt mutual funds. If you didn’t set off this gain of Rs 3.33 lacs, you will have to pay a tax of Rs 1 lac. This is now saved.
You buy back the stock at Rs 200. After some time, the stock goes to Rs 350 and you sell your holding
You buy back the stock at Rs 200. After some time, the stock goes to Rs 350 and you sell your holding at Rs 11.66 lacs, resulting in short-term gain of Rs 5 lacs. Now, let’s consider the two possibilities.
Case 1 (without tax-loss harvesting)
You have STCG of Rs 3.33 lacs in debt funds. Your marginal tax rate is 30%.
You have STCG of Rs 1.66 lacs in stock sale.
Total tax paid= Rs 3.33 lacs * 30% + 1.66 lacs *15% = Rs 1 lac + 25,000 = Rs 1.25 lacs
Case 2 (with tax-loss harvesting)
You have STCG of Rs 3.33 lacs in debt funds.
You use the above STCG with STCL in the sale of stocks. Hence, there is no tax liability.
On eventual sale, you have STCG of Rs 5 lacs (on share ABC).
Total tax paid = Rs 5 lacs * 15% = 75,000
You can see, you have been able to reduce tax liability due to tax loss harvesting.
Remember, this works because STCG in equity is taxed at a lower rate than STCG in debt funds.
This approach won’t be too effective if:
- If your marginal tax was lower. If you were in 10% tax bracket, your total tax liability will be ~Rs 58,333 (Case 1). Tax loss harvesting is no use.
- If your gains on the sale of debt mutual funds were long term capital gains. LTCG in debt funds is taxed at 20% after indexation. Considering levels of indexation in the recent past, this will range from 10% to 15%. STCG in equity is taxed at 15%. Hence, this won’t really be helpful. You can do this to delay paying taxes though.
For this exercise to be useful, this capital gains tax rate on loss-making capital asset must be lower than the rate on gain making capital asset. The greater the difference, the better it is.
Points to Note
- If you have invested in equity mutual funds, the resulting loss is STCL if you have sold within 1 year. However, most actively managed mutual funds have an exit load of 1% if you exit the fund before 1 year. Now, this is friction and adds to the cost of tax-loss harvesting.
- Index funds usually don’t have exit loads beyond certain days. Hence, these can be quite useful.
- Stocks/mutual fund investments work on First-in First-out (FIFO) basis. The stocks/units that were purchased first are sold first. Thus, it is possible that you want to book loss by selling short term units. However, for you to be able to sell those, you must sell long term units too. Now, the taxation of LTCL/LTCG in equity/equity funds works is slightly complex. LTCG up to Rs 1 lac is exempt. This can upset your equation.
- Let’s say you have already booked LTCG to the extent of Rs 1 lac in the financial year. To sell short term units, you must first sell long term units and book LTCL of Rs 60,000. If you do that, your total LTCG on equity in the year comes to Rs 40,000. Now, this 60,000 of LTCL has gone waste. If you had booked this in the next year, this could have helped you save some tax. Trust your judgement on this.
- If you have invested in stocks, there will be brokerage, STT involved in selling the investment (and buying it back).
- I have considered the example of only STCL in equity/equity funds. You can similar calculations for your other assets and see if this helps. For instance, you can use LTCL in equity funds to set off STCG in shares/equity funds or STCG in debt funds.
- When you sell a share/fund unit and buy back, the meter for holding period restarts. You must keep this in mind. Let’s say you bought a stock on October 31, 2019, and sold it on March 1, 2020 and booked losses. If you buy it back on say March 1 (different exchange), 2020, the meter restarts. Now, this investment will complete 1 year on March 1, 2021. Had you not sold, your erstwhile investment would have completed 1 year on October 31, 2020. You might want to consider this since LTCG is taxed at a lower rate.