How Tax loss Harvesting can help you save Capital Gains Tax?

If you rush to make tax-saving investments in the months of February and March, it is appropriate that you also try to reduce tax liability on your capital gains through tax loss harvesting. After all, both serve the same purpose. Reduce your tax outgo.

In this post, we look at the concept of tax loss harvesting, where you use (or intentionally book) capital losses to set off capital gains. You can use tax-loss harvesting to reduce your capital gains tax liability. Before that, let’s first look at capital gains set-off provisions. This is important because it is these provisions that enable tax-loss harvesting.

Tax-Loss Harvesting: Set off of Capital Gains

Short-term capital loss (STCL) from the sale of any capital asset can be used to set off:

1. Short-term capital gains (STCG) from the sale of any capital asset
2. 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:

1. 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 equity mutual funds to set off STCG/LTCG from the sale of equity funds/shares/debt funds/gold/bonds/real estate etc.

This way, you can bring down your capital gains tax liability.

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 assets. You plan to buy it back after a few days (or even on the same day). However, this sale and repurchase of the asset may help you save capital gains tax.

Loss in LOW Tax Asset and Gain in HIGH Tax Asset

The tax-loss harvesting is the most useful when you book capital losses in Asset A (where capital gains are taxed at a lower rate) to set off capital gains in Asset B (where capital gains are taxed at a higher rate).

For instance, you have short-term gains of Rs. 5 lacs on the sale of debt mutual funds, which in your case will be taxed at say 30%. Now, let’s say you have an opportunity to book short-term capital loss of Rs 5 lacs in equity funds (where STCG is taxed at 15%).

You sell such equity investments to book Short term capital loss of Rs. 5 lacs. This loss will square off capital gain of Rs 5 lacs.

In absence of this tax-loss harvesting exercise, you would have had to pay capital gains tax of Rs 1.5 lacs (Rs 5 lacs X 30%). After tax-loss harvesting, you do not have to pay any tax.

You can always buy back the equity investment after a few days (or even on the same day) and maintain your equity position.

A few points to consider

1. Usually, when you sell your equity funds before the completion of 1 year, you might have to pay exit load. This adds to transaction costs. However, there are no such issues when you sell stocks or even index funds. Index funds have exit loads for only a few days.
2. The idea is to buy back the asset. The asset price (stock price or fund NAV) might go up when you plan to buy it back, reducing the impact of tax-savings.
3. Purchase and sale of assets involves costs (exit load, brokerage, STT etc).
4. When the buy the asset back at a lower price, your cost price gets adjusted downwards, effectively increasing your future tax liability. Your cost price was 12 lacs. You sold for Rs 7 lacs to book capital loss of Rs 5 lacs. Bought back at Rs 7 lacs. Now, Rs 7 lacs is the new cost price. In the future, you sell the fund units for Rs 12 lacs. Your capital gain will be Rs 5 lacs. You pay 15% tax (assuming short term) on it. Rs. 75,000 on capital gains tax. Had you not done tax loss harvesting, there wouldn’t have been any capital gains and hence no tax.
5. However, by doing tax-loss harvesting, we saved Rs 1.5 lacs upfront. And your future tax liability is only Rs 75,000. In fact, if such gains were long term, the future tax liability will only be Rs 50,000.

STCG on equity is taxed at 15%. LTCG on equity is taxed at 10%.

STCG on debt (and most other assets) is taxed at marginal rate. LTCG is taxed at 20% after indexation.

As mentioned earlier, you want to book loss in LOW tax asset to set off gains in HIGH tax asset.

Your marginal tax rate may be different. Indexation may be higher or lower.

So, you must decide accordingly.

The short-term capital gains are usually taxed at a higher rate. Thus, you may want to set off STCL against short-term capital gains. Not necessary though.

Interesting bit about Sovereign Gold Bonds

Sovereign gold bonds have this interesting quirk. If you hold the bonds until maturity, you do not have to pay any capital gains tax (Section 47 of the Income Tax Act).

If your Sovereign Gold Bonds are trading at a loss, you can simply sell those gold bonds in the secondary market and book losses. You can use such losses to set off capital gains in any other assets.

You can buy back the bonds after a few days. The interesting part is that this does not even increase your future tax liability.

Why?

Because any capital gains on maturity is exempt from tax. In fact, the way the tax laws are worded, the redemption of gold bonds does not even constiute a transfer and hence does not even result in capital gain.

Let’s say you invest Rs 10 lacs in gold bonds about 6 months back. Now, the value is down to Rs 9 lacs. You sell the gold bonds and book loss of Rs. 1 lac. Use this loss to set off capital gains from other assets. After a few days, you buy back the gold bonds (let’s say for Rs 9 lacs). Your cost price gets reset to Rs 9 lacs. Even if the bonds mature for valuation of Rs 12 lacs, you don’t have to pay any tax since the maturity proceeds are exempt from tax.

You buy at 10 lacs. Hold to maturity. Redeem for 12 lacs. You don’t pay any tax on gain of Rs 2 lacs.

You buy at 10 lacs. Sell at 9 lacs and book loss of Rs 1 lac. Set off short term gain of Rs 1 lac and save Rs 30,000 in tax. Buy back the bonds at Rs 9 lacs. Redeem for Rs 12 lacs. You don’t pay any tax on gain of Rs 3 lacs.

Which approach do you think is better?

Now, let’s look at tax loss harvesting opportunities with in the same asset. We consider equity funds.

Tax Loss Harvesting: Reduce tax liability during portfolio 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:

1. Portfolio Rebalancing
2. Switch from regular to direct plans of mutual fund schemes

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. Not any longer.

However, 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 the calculations simple.

Illustration

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?

Fair enough.

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

1. You may not always have losses for tax harvesting. Good luck or bad luck, depending on the way you look at it.
2. 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 the sale of equity fund units.
3. You could have also used STCL on any other capital asset to set off LTCG on sale of equity funds units.
4. Sale and purchase of assets have certain transaction costs too. Keep such costs into account while making a decision.

Source/Additional Links

Income Tax Website

ClearTax: Set off/Carry Forward of Losses

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.