The markets are in a nosedive and many investors are concerned about the value of certain assets in their portfolio. What if I told you that there was a way to use these assets to increase the overall post-tax returns on your portfolio? Yes, you read that right! Tax Loss Harvesting is a way to use the assets from your portfolio that have lost value to increase the post-tax returns of the other well-performing assets. Today, let’s take a look at tax-loss harvesting and try to understand how it works. Read on!
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What is Tax Loss Harvesting?
When you invest in equity-oriented mutual funds, you either make capital gains or losses. These are defined as long-term and short-term based on the duration for which you hold the units of the fund. Currently, short-term capital gains (STCG) are taxed at 15% while long-term capital gains (LTCG) above Rs. 1 lakh are taxed at 10% without indexation.
The Income Tax Department allows investors to set-off capital losses against capital gains to reduce tax liability. This means that in a financial year if you have made short-term capital gains of Rs.50000 and short-term capital losses of Rs.10000, then you need to pay tax on the net gain of Rs.40000 (50k – 40k) only.
In Tax Loss Harvesting, you sell those stocks and/or equity fund units that have little or no chance of recovering from their current levels, at a loss. This helps in reducing the tax liability on capital gains. While most investors try harvesting their capital losses at the end of the financial year, you can use it as a regular process to maintain your annual capital gains at a low level.
How does Tax Loss Harvesting work?
To understand how tax-loss harvesting works, let’s use an example:
Saurabh has an investment portfolio spread across stocks, equity funds, debt funds, etc. At the end of the financial year, Saurabh’s portfolio performed as follows:
- Short-Term Capital Gains = Rs.80,000
- Long-Term Capital Gains = Rs.150,000
Hence, Saurabh’s tax liability is as follows:
STCG Tax = 80000 x 15% = Rs. 12000
LTCG Tax = (150000 – 100000) x 10% = Rs. 5000
Total tax liability = 12000 + 5000 = Rs. 17,000
However, Saurabh notices that certain stocks in his portfolio have reached low levels with minimal chances of recovery. He talks to an investment advisor who recommends using tax-loss harvesting. He sells those stocks and books a short-term capital loss of Rs. 30,000. Then, he uses the amount received to invest in more-promising stocks or equity funds. Hence, his tax liability becomes:
STCG Tax = (80000 – 30000) x 15% = Rs. 7500
LTCG Tax = Rs. 5000
Total tax liability = 7500 + 5000 = Rs. 12,500
Hence, he manages to save Rs.3500 in tax. Also, since he has invested the sales proceeds in another stock/mutual fund, there is a chance to recover the losses if the stock/fund performs well. This helps him maintain the asset allocation of the portfolio.
March 2020 has been a bad month for equity investors with markets in a literal nosedive. Although December 2019 and January 2020 were good months for the markets, the fear of the economic impact of Covid-19 sent markets into a frenzy in February and March this year. Here is a quick look at how the Nifty 50 Index performed over the financial year 2019-20:
Source: Yahoo Finance
If you were invested in the markets during the financial year and realized some capital gains, then you can use the current market crash to book some capital losses and reduce your tax liability by implementing tax loss harvesting.
Some Tips before you implement Tax Loss Harvesting
- Tax-loss harvesting means selling some assets at a loss to reduce tax liability. There is no way to guarantee that you will recover those losses.
- You can set-off long-term capital losses against long-term capital gains only. On the other hand, short-term capital losses can be set-off against both LTCG and STCG.
- If you are planning to implement tax-loss harvesting yourself, then ensure that you calculate your tax liability carefully before deciding to sell your investments at a loss.
- While investing the redemption proceeds of the loss-making trade, ensure that you don’t take excessive risks to cover the losses. Keep your portfolio’s risk-return profile in mind.
- Its not wise to use tax-loss harvesting as an investment strategy. This is beneficial for tax saving purposes alone.
If every coin has two sides, then the only advantage of the current market crash is the opportunity to reduce your tax liability by using tax-loss harvesting. We hope that this guide helped you understand how to harvest your capital losses and save taxes. If you have any further questions, drop us a line and we will be glad to be of assistance.
Disclaimer: The views expressed in this post are that of the author and not those of Groww.