What is tax-loss harvesting? How does it help to reduce taxation burden on capital gains?

Tax-loss Harvesting Strategy: Are you someone who pays capital gains tax? If yes! then you should be aware of ‘tax-loss harvesting’, a strategy that takes advantage of capital losses to offset capital gains and potentially reduce your overall tax bill. By strategically selling investments at a loss, you can get a tax benefit that can be used to lower your tax burden.

Capital gains tax is levied on the profit you make from selling stocks, real estate, and a few other assets. The tax is calculated on the difference between the selling price and your original purchase price (called the cost basis).

Long-term capital gains: They apply to assets held for longer than a specific period (usually one year). These gains often benefit from lower tax rates compared to income tax brackets.

Short-term capital gains: They apply to assets held for one year or less and are typically taxed at your ordinary income tax rate.

Taxpayers can avail the benefit of tax loss harvesting against short-term capital gains as well as long-term capital gains. However, taxpayers need to take into consideration that long-term capital losses can only be set off against long-term capital gains, whereas short-term capital losses can be set off against both short-term and long-term capital gains.

Moreover, long-term capital gains on the sale of listed shares or equity-oriented mutual fund units enjoy a threshold of Rs 1 lakh, up to which the gains are tax-exempt u/s 112A.

Suresh Surana, Founder, RSM India, said that taxpayers should note that previously long-term capital gains were exempt in the hands of investors. However, Budget 2018 revoked such exemption and imposed tax at the rate of 10 per cent u/s 112A of the IT Act. Accordingly, the budget also clarified that LTCG on the sale of listed shares or equity-oriented mutual funds is exempt up to Rs. 1,00,000.

“Investor need not opt for tax loss harvesting in case his/her LTCG does not exceed Rs 1 lakh. Further, it is pertinent to note that loss on Casual Incomes (i.e. Loss from Card Games, Lotteries, Gambling, etc.) are neither allowed to be setoff against any head of income nor are they allowed to be carried forward for utilization in the future years.” he said.

The intention behind tax loss harvesting is to sell securities at a loss to offset capital gains from other investments or to reduce taxable income. Here is a calculation of this strategy, which shows that you can reduce up to Rs 30,000, including your short-term and long-term capital gains.

We assumed an amount of Rs 6,00,000 for the short-term capital gains (STCG) and Rs 5,50,000 for the long-term capital gains (LTCG), then the total amount is Rs 1,150,000.

For Instance, Mr. A has short-term capital gains (‘STCG’) and long-term capital gains (‘LTCG’) of Rs 6,00,000 and Rs 5,50,000, respectively, and since LTCG u/s 112A of the IT Act is exempt up to Rs. 1,00,000, the taxpayer’s net LTCG liable to tax amounts to Rs 4,50,000.

In case Mr. A opts for tax loss harvesting and books a short-term capital loss and long-term capital loss of Rs 1,00,000 and Rs 1,50,000, respectively, the amount of capital gains subject to tax would be Rs 8,00,000 ( i.e. Rs. 3 lakhs LTCG subject to tax at 10 per cent u/s 112A plus Rs 5 lakhs STCG 15 per cent u/s 111A of the Act).

Accordingly, the total tax liability (after tax loss harvesting) comes down to Rs 1,05,000.

In cases otherwise, Mr. A’s aggregate tax liability pertaining to capital gains amounts to Rs 1,35,000 (i.e., STCG tax at 15 per cent u/s 111A of the Act of Rs 6,00,000 and LTCG at 10 per cent u/s 112A of the IT Act of Rs 4,50,000).

In the above calculation, it is easily understood that the total capital gain (STCG + LTCG) of Rs 1,150,000, on which the total taxation is Rs 1,35,000, you can convert it to Rs 1,05,000. Hence, Rs 30,000 is easily saved with the tax-loss harvesting strategy.

Inflation will make your investment lose value over period of time, which can affect your strategy. The expert explains how tax-loss harvesting gets affected:

Inflation vs real loss: Inflation reduces the value of invested money over time. It means a nominal loss may not necessarily represent a real loss after accounting for inflation.

When considering tax-loss harvesting, investors should account for inflation to determine if the loss is significant enough to warrant selling the investment for tax purposes, said Surana.

Tax benefit vs future growth: Selling a losing investment helps you save taxes, but you miss out on any future profits if it goes up. Think twice before selling just for tax reasons, especially with inflation.

Reinvesting during inflation: When you reinvest money from a sale, inflation can reduce its buying power. So you might need to find investments with higher returns to make up for it.

If you want to use this strategy, first of all, you need to know who can benefit from it:

• Investors in higher tax brackets, as their tax liability would be significantly reduced by intentionally booking losses and claiming offset for the same.
• Taxpayers with long-term Investors as they do not expect to realise their returns over a short period of time.
• Long-term investors who are also taxpayers do not expect to realise their returns over a short period of time.
• Taxpayers with diversified portfolios who suffer loss in one investment can use tax loss harvesting to offset gains in other investments.
• Those who have diversified portfolios and are also suffering losses in one investment can use this strategy to offset gains in other investments from their portfolio.