Introduction on tax on the long-term capital gain (LTCG) on the sale of equity funds/shares is a clear pain point for the equity investors.
If you rebalance your portfolio at regular intervals (which you should) or have been planning to switch your regular plan investments to direct plan, you will have to incur some cost now.
Earlier (before the introduction of the tax on LTCG), you could have rebalanced your portfolio without any tax cost (at least if you had to move funds from equity to debt). Ditto for moving from regular to direct plans of equity fund schemes.
Now, you will have to incur tax cost.
In this post, we look at the concept of tax loss harvesting, which you use your capital losses to set off capital gains. You can use tax loss harvesting to reduce your capital gains tax liability.
Set off of 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.
You can use STCL from sale of debt mutual funds to set off STCG from sale of equity funds/shares/debt funds/gold/bonds/real estate etc.
This way, you can bring down your capital gains tax liability.
Long Term Capital Loss (LTCL) on sale of equity shares/equity mutual fund units
Earlier, long-term capital gains of sale of equity shares/ equity mutual fund units were exempt from tax. The common understanding was that set off for losses were allowed only for assets where capital gains were taxed. Since LTCG on sale of equity mutual fund units was exempt from tax, LTCL on sale of equity shares/fund units could not be used to set off capital gains.
However, with Budget 2018, this has changed. Now that LTCG on sale of equity is taxable, LTCL arising due to the sale of shares/equity mutual funds will also be allowed to set off capital gains.
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 loss 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 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.
Using Tax Loss Harvesting to reduce tax liability while rebalancing or switching from regular to direct
Due to the introduction of tax on LTCG on sale of equity funds, taxes became a cost for the following activities:
- Portfolio Rebalancing
- Switch from regular to direct plans of mutual fund schemes
Even though tax on LTCG is a cost on any sale of equity fund units, we can’t do much about that.
In case of rebalancing or switching from regular to direct, Tax loss harvesting (coupled with exemption of LTCG up to Rs 1 lac in case of sale of equity) can bring down liability to some extent.
Let’s consider an example. I have picked up an example to avoid Grandfathering provisions and keep calculations simple.
You made an investment of Rs 10 lacs each in Fund A and Fund B. Both are equity funds.
After 18 months, the value of the investment in Fund A is 9 lacs.
The value of investment in Fund B is 13 lacs.
Let’s assume you made the investment in Regular plan of Fund B and need to shift to Direct Plan of Fund B.
Case I (without tax loss harvesting)
You switched units of Fund B alone from Regular to Direct.
You will make LTCG of Rs 3 lacs. Rs 1 lac is exempt. Hence, you will have to pay a tax of 10% on the remaining Rs 2 lacs.
Total tax liability of Rs 20,000 (excluding cess and surcharge).
Case 2 (with tax loss harvesting)
You switched units of Fund B from regular to Direct, and the same time sold units of Fund A. You buy back the units of Fund A after a few days.
You will incur LTCG of Rs 3 lacs in Fund B and LTCL of Rs 1 Lac in Fund A.
Your net capital gain will be Rs 2 lacs. After accounting for exemption of Rs 1 lac per financial year, your net taxable long term capital gain is Rs 1 lac.
Total tax liability of Rs 10,000 (Rs 1 lac * 10%)
Tax payable without tax loss harvesting = Rs 20,000
Tax payable with tax loss harvesting = Rs 10,000
Through tax loss harvesting, you saved capital gains tax worth Rs 10,000.
You can employ a similar strategy while rebalancing your portfolio.
You may argue
Tax loss harvesting may only lead to deferral of taxes.
Because now, the cost price of units in Fund A has gone down by Rs 1 lac. Eventually, when you sell these units of Fund A in the future, you will have to shell out Rs 10,000 extra that you saved today.
For example, if you had not sold units of Fund A, your cost price would have been Rs 10 lacs. Suppose you sell the units after 5 years for 15 lacs. Your capital gain will be Rs 5 lacs. After accounting for exempt LTCG of Rs 1 lac, you have taxable LTCG of Rs 4 lacs.
Total Tax Liability = Rs 4 lacs *10% = Rs 40,000
Now that you have sold and repurchased at Rs 9 lacs, your cost price is now Rs 9 lacs. When you sell for Rs 15 lacs later, your gain will be Rs 6 lacs. Taxable LTCG = Rs 5 lacs.
Total Tax liability = Rs 5 lacs * 10% = Rs 50,000
So, you are paying Rs 10,000 extra after 5 years.
Where is the saving, you may ask?
Well, what about time value of money? Paying Rs 10,000 after 5 years is better than paying Rs 10,000 today. Isn’t it?
What if you used tax loss harvesting for rebalancing your portfolio? i.e. you did not put the money back into Fund A. You simply wanted to move funds from an equity fund to a debt fund. In this case, this is a neat saving.
Points to Note
- You may not always have losses for tax harvesting. Good luck or bad luck, depending on the way you look at it.
- I have used LTCL on equity funds in this example. You could have used LTCL on any other capital asset (bonds, real estate, gold etc) to set off gain on LTCG on sale of equity fund units.
- You could have also used STCL on any other capital asset to set off LTCG on sale of equity funds units.
- You may want to avoid selling your equity fund units before completion of 1 year because you are likely to face exit penalty (or exit load). Moreover, STCG on sale of equity funds units is taxed at a higher rate (15%).
- Sale and purchase of assets have certain transaction costs too. Keep such costs into account while making a decision.
Disclaimer: I am not a tax expert or a Chartered Accountant. You are advised to talk to a tax consultant or a Chartered Accountant before you make a decision.