Tax Loss Harvesting

Investment in equity helps you make capital gains. A capital gain is when you make a profit by selling an asset that has increased in value over a period. Depending on how long you stay invested, these capital gains are taxed.

A long-term capital gain, sometimes referred to as LTCG tax, is levied when you earn profits on selling equity investments held for over a year. However, short-term capital gains (also referred to as STCG) tax is applied when you make a profit by selling the assets held for less than a year.

The Union Budget of 2018 introduced LTCG tax on profits earned from selling equity shares and funds held for over a year. So, now LTCGs exceeding ₹1 lakh attract 10% tax with no indexation benefit. On the contrary, STCGs are taxed at 15%.

Capital gains tax can take a significant portion of your investment returns. This is where tax loss harvesting comes in. It involves strategic selling of underperforming assets in your portfolio to realise or “harvest” a loss. The losses are used to offset capital gains and save on taxes on profitable investments. This lowers your tax bill for a financial year.

In other words, tax loss harvesting is a technique where capital losses are incurred to counterbalance capital gains with the final goal of reducing taxes. It is beneficial if you have a taxable investment account. As an investor, you can use tax loss harvesting to reduce tax outgo on both LTCGs and STCGs. This technique can be used in capital assets, including shares and mutual funds. When used in context with mutual funds, it is referred to as tax-harvesting mutual funds.

Usually, investors use the strategy for STCGs since the tax rates are higher on these. While many investors use tax loss harvesting at the end of the year, you can use it throughout the year to lower your capital gains.

Now that you know what is tax harvesting, let's understand how it works.

Suppose you have invested in listed shares. Instead of appreciation, the value of a few assets in your portfolio declines below the purchasing price, with no hope of recovering soon. Such investments stand at a “loss position”. The silver lining is that you can use these assets to save on taxes via tax loss harvesting. Selling these assets at a loss can help you offset the profits from selling other assets. You can also reinvest the amount realised from the sale of loss-making assets to maintain your portfolio’s asset allocation.

Once you have calculated your tax liability on capital gains, follow these steps for tax loss harvesting:

Step 1: Identify tax loss harvesting opportunities

The first step is to identify the investments in your portfolio that are at a “loss position” or underperforming, especially when the market is down. These can include stocks, mutual funds and other investments that are subject to capital gains tax

Step 2: Realise the loss

Sell the loss-making assets to realise a capital loss. Remember, you can counterbalance long-term capital losses against long-term capital gains only. However, you can counterbalance short-term capital losses against both short-term and long-term capital gains.

Step 3: Assess your tax liability

Now calculate your tax liability on net capital gains. Use the loss to reduce or eliminate taxes you would have otherwise attracted

Step 4: Reinvest

Consider reinvesting the proceeds in another asset from the same sector based on your investment goals and risk tolerance. This helps in maintaining the sectoral balance of your portfolio.

Assume an investor named Mr Deepak earned STCGs of ₹1 lakh in a financial year. According to the rules, he must pay a 15% tax on the gains. This amounts to ₹15,000. Now, let’s consider that some stocks in his portfolio are underperforming. The loss he will incur by selling these stocks amounts to ₹60,000.

If Mr. Deepak decides to sell these loss-making assets, the value of his gains can come down to ₹40,000. A 15% tax will apply to ₹40,000 instead of ₹1 lakh. So, by using tax loss harvesting, Mr Deepak can reduce his tax liability to ₹6,000 and save ₹9000. He can also invest the sale proceeds in similar stocks or mutual funds immediately after the sale. This will help him recover from the loss and maintain his portfolio diversification.

Tax loss harvesting is a legal way of reducing your tax bill. It can be used even by average investors. However, a few important things must be considered before using the technique:

• Every tax loss harvesting decision must rely on the fact that tax rates on STCGS are much higher than on LTCGs.

• Evaluate your tax burden carefully if you are planning to practise tax loss harvesting yourself before selling your investments at losses.

• Tax loss harvesting involves selling unprofitable assets at a loss to offset capital gains on profitable investments. However, there is no guarantee you will recover from the incurred losses.

• LT capital losses can be adjusted against LT capital gains only.

• You can adjust ST capital losses against ST as well as long-term capital gains.

• Consider reinvesting the amount immediately after redemption. If not invested, you may lose out on the compounding benefit.

• Don’t take too much risk while reinvesting the proceeds from underperforming assets to overcome the loss. Always analyse your risk tolerance before making an investment decision.

• Use tax loss harvesting for tax-saving purposes only and not as an investment strategy. If you think an investment is going to give good returns in the future, keep holding it.

As an investor, you can significantly reduce your tax liability through tax loss harvesting. The strategy can be beneficial if you have a taxable investment account with long-term investments. However, assessing your tax liability and cost-benefit ratio before opting for tax loss harvesting in India is crucial. Also, consulting a professional before implementing the strategy is recommended to avoid pitfalls.

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