What is tax-loss harvesting? Does it help to reduce capital gain taxes?

Are you an active investor or a trader in the stock market? Then you would have heard the term tax-loss harvesting. If not, then let us take you through what it means.

The financial year is at its ending. Those who invested in the fall of March 2020 would have booked enormous gains. As the stock market has gone up by almost 90% since the onset of the pandemic in the last year. 

What is tax-loss harvesting?

When you start investing, the main aim is to earn money from your investments. But one has to embrace the reality that if some stocks perform well in a well-diversified portfolio, few of them do not even provide a break-even.

Tax-loss harvesting is a tool used by the traders/investors by selling off the securities with negative returns at a loss to offset the capital gain tax liability. Tax-loss harvesting is also known as “tax-loss selling.” Usually, this strategy is implemented near the end of the financial year, but you can harvest your losses at any time in a particular financial year to reap the benefits. Although tax-loss harvesting cannot restore an investor to their previous position, it can reduce the loss’s severity. For example, a loss in Security X’s value could be sold to offset the increase in Security Y’s price, thus eliminating the capital gain tax liability of Security Y.

This method is mainly used for short-term capital gains as they are taxed at slightly higher rates than long-term gains. However, you can also use this strategy for long-term gains. 

When an investor sells an investment for profit, the gains are either long term or short term. Any investment held for more than a year is considered a long-term gain, and less than a year will result in short-term gains. Long-term investments attract LTCG tax at 10 per cent above Rs 1 lakh, whereas short-term investments are taxed at 15%.

Tax-loss harvesting is a strategy that can be used to turn off a portion of capital losses into tax offsets to reduce the outflow of capital gain tax. When you sell off some of your investments at a loss to offset the gains realized on other stocks, by doing this, you have to pay taxes on net gains only. 

Investors can proceed by selling off the floundering investments in return to purchase an asset with similar nature to maintain the portfolio allocation.  

One has to keep in mind that if you wish to harvest losses and offset them against gains, the entire sale transaction should be completed within the financial year, i.e. before 31st March.

While harvesting helps to reduce the tax liability on the capital gains of the particular financial year, the Income Tax Act allows you to carry forward the capital losses for eight consecutive years. This provision can help you harvest the losses of the investments whose chances of improvement are bleak shortly. For such investments, you can book losses and can carry forward them for offsetting against future capital gains.

How to calculate the losses?

If you have made a lump-sum purchase of an investment, then calculating gains and losses is a simple task. The difference between purchase and sales of the stocks will give you the number of capital gains or losses. However, if the investment you wish to harvest was invested through SIP mode, then its record keeping is a challenge. You will have to get the details of each purchase’s date and value to calculate the holding period and gains/losses separately for each SIP transaction.  

Example of Tax-Loss Harvesting

Assume Mr Ankur is an investor with the below-mentioned portfolio:

Portfolio:

• Mutual Fund X: Rs.3,50,000 unrealised gain, held for 380 days
• Mutual Fund Y: Rs.130,000 unrealised loss, held for 635 days
• Mutual Fund Z: Rs. 100,000 unrealised loss, held for 138 days

Trading Activity:

• Mutual Fund A: Sold, realised a gain of Rs.300,000. Fund was held for 380 days.
• Mutual Fund B: Sold, realised a gain of Rs.150,000. Fund was held for 150 days.

Without tax-loss harvesting, the tax liability from this activity is:

• Tax without harvesting = (Rs.(300,000-100000) x 10%) + (Rs.150,000 x 15%) = Rs.20,000 +Rs.22,500 = Rs.42,500

The investor harvested losses by selling mutual funds Y and Z, which helps to offset the gains, and the tax liability would be:

Tax with harvesting = ((Rs.300,000 – Rs130,000 – Rs.1,00,000)) x 10%) + ((Rs.150,000 – 100,000) x 15%) = Rs. 7000 + Rs.7,500 = Rs.14,500

Thus, by harvesting losses of mutual funds Y and Z, the tax liability can be reduced from Rs.42,500 to Rs. 14,500, i.e. Rs.28000 can be saved on capital gain taxes. Using the tax-loss harvesting strategy, investors can realise significant tax savings. However, they should be cautious that only those stocks which have a long-term negative impact and little chance of improvement should be harvested.  

For any clarifications/feedback on the topic, please contact the writer at jyoti.arora@cleartax.in