Optimize Capital Gains by Tax Loss Harvesting
Looking for a smart way to reduce your tax liability while optimizing your investment strategy? Tax loss harvesting might just be the solution you need. By strategically selling equity investments (equity shares or units of mutual fund) that are trading below market price, you can offset gains from other parts of your portfolio, lowering your taxable income and potentially boosting your returns. It's a powerful, yet often overlooked, tool that savvy investors use to maximize their financial outcomes. In this article, let's dive into how tax loss harvesting can help you optimize your after-tax long-term capital gains.
What is TAX LOSS HARVESTING?
- Tax-loss harvesting is the practice of selling a security that are trading below the purchase price to help you reduce or offset taxes on any capital gains income subject to taxation. This practice is accomplished by harvesting the loss.
- The strategy isn't just about minimizing losses. It's about strategically using them to improve your after-tax returns
How does it work?
Tax loss harvesting is typically implemented before year ends, during portfolio performance reviews. This strategy involves selling the securities that are trading below purchase price to offset capital gains realized from other profitable investments.
The key is to intentionally book the losses by selling the securities that have declined in value i.e., to counterbalance the gains from other investments, thereby reducing capital gains and taxes thereon. The securities sold at loss are typically repurchased the following day. Impact of price change will be minimal as such securities are bought back immediately on next trading day.
The key is to intentionally book the losses by selling the securities that have declined in value i.e., to counterbalance the gains from other investments, thereby reducing capital gains and taxes thereon. The securities sold at loss are typically repurchased the following day. Impact of price change will be minimal as such securities are bought back immediately on next trading day.
Without Tax Loss Harvesting:
- Mr. A has realized long-term capital gains of Rs. 20,00,000.
- Section 112A of the Income Tax Act offers an exemption of up to Rs. 1,25,000 on long-term capital gains from the sale of securities. (You may want to refer to our previous newsletter, where we have discussed in detail how to utilize the exemption under Section 112A.)
- Therefore, his taxable gains are: Rs. 20,00,000 - Rs. 1,25,000 = Rs. 18,75,000.
- The tax rate on these gains is 12.5%, so the tax payable would be: Rs. 18,75,000 × 12.5% = Rs. 2,34,375.
Incorporating the Tax Loss Harvesting Strategy:
Mr. A owns following securities which are trading at below their purchase price -
| Name of Security | No. of units held | Purchase price (in Rs) | Last Trading price (in Rs) | Decline in Value (in Rs) |
|---|---|---|---|---|
| PQR | 500 | 1000 | 500 | 2,50,000 |
| STV | 250 | 2000 | 500 | 3,75,000 |
| XYZ | 500 | 500 | 250 | 1,25,000 |
| Total Decline In Value Of Investment | 5,00,000 | |||
- By selling the securities PQR, STV and XYZ where value of investment has declined, he can book a loss of Rs. 5,00,000, which will offset his taxable gains.
- Now, his taxable gains become: Rs. 20,00,000 - Rs. 1,25,000 (exemption) - Rs. 5,00,000 (loss due to decline in value) = Rs. 13,75,000.
- The tax payable on these reduced gains is: Rs. 13,75,000 × 12.5% = Rs. 1,71,875.
Tax Savings from Tax Loss Harvesting:
- By incorporating the tax loss harvesting strategy, Mr. A has reduced his taxable gains by Rs. 5,00,000.
- Consequently, his tax payable has decreased by: Rs. 2,34,375-Rs. 1,71,875 = Rs. 62,500.
Important Consideration:
- The strategy of tax loss harvesting requires Mr. A to repurchase the same securities (PQR, STV and XYZ) the very next trading day after selling it. This is to maintain his market exposure while reducing the tax liability.
- While there is no explicit regulation in India that disallows tax loss harvesting, it is advisable for clients trading and investing in India to consult a Chartered Accountant before filing income tax returns.
SET OFF & CARRY FORWARD RULES
Section 74 of The Income Tax Act, 1961 talks about the set off and carry forward of Capital Gain Losses -
Set Off Rules:
Short-Term Capital Loss: This loss can be set off against capital gains for that assessment year from any capital asset. Simply speaking, short term capital loss can be set off against short term as well as long term capital gains.
Long-Term Capital Loss: Long term capital loss can be set off only against long term capital gains.
Long-Term Capital Loss: Long term capital loss can be set off only against long term capital gains.
Carry Forward of Losses
If there are no capital gains in a particular year to offset your capital losses, the Income Tax Act allows you to carry forward the losses for up to 8 assessment years following the year in which the losses were incurred.
Conclusion
- Since past 4 months, the market has seen a healthy correction, with NSE large cap index sliding down by 13.27%, NSE mid cap index falling down by 12.85% and NSE small cap dropping by 9.87%. There is a good opportunity to book the losses by selling underperforming securities to offset gains from other investments and thereby reducing tax liabilities.
- Thus, in conclusion, it is fair to say that despite the reintroduction of LTCG tax, there are ways and means to minimize its impact to keep your returns intact. Having said that, each individual has a different portfolio and different financial goals. It is thus prudent to seek advice from a financial advisor before deciding your investment strategy.