 "mutual funds, MFs")
High taxes is the last thing anyone wants on their financial statements, and when you make an investment, especially in equities, you would look for tax effiency. Since mutual funds are one of the most popular investment avenues in India today, here are useful hacks to be ensure tax efficiencies.
The Union Budget in 2018 imposed a 10 per cent tax on long term capital gains (LTCG) on realised equity gains over Rs 1 lakh in a financial year. But there's an exception to it. The LTCG on equity up to Rs 1 lakh in a financial year is tax-exempt.
Tax harvesting
"It’s easy to overlook the taxes on capital gains made on your investments because they are not deducted at source like a tax on salary. This means that you need to manage your investments and calculate your tax liability actively or you might end up paying more taxes than necessary.This is where tax harvesting comes in. By selling off your losing stock investments or mutual funds, you can offset your gains and reduce your tax liability," said Naveen K R, Senior Director, Windmill Capital, a Sebi registered research analyst.
Tax harvesting involves selling a loss-making security by realizing or “harvesting” the loss. This method helps investors to easily offset taxes applicable on gains or income. In this method, one has to ensure that the securities move out of the taxpayer’s Demat account via a sale or delivery transaction and subsequently buy them the following day.
Anup Bansal, Co-founder, Scripbox, explains how investors can lower their overall taxable incom with the following three options:
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1. Identify investments with capital Losses: Investors need to review their investment portfolio to identify assets that have decreased in value since their purchase. These losses can be used to offset capital gains.
2. Sell Underperforming Investments: Once investors have identified investments with capital losses, they can choose to sell them. However, it's important for investors to consider their long-term investment strategy and whether the assets are likely to recover in value.
3. Offset Capital Gains: The capital losses realized from selling underperforming investments can be used to offset capital gains made on other investments. Long-term capital losses can offset long-term capital gains, while short-term losses can offset short-term and long-term gains. If the losses exceed the gains, the remaining loss can be carried forward to the subsequent years to offset future capital gains.
In tax loss harvesting, losses are realized and used to offset gains in other instruments
Let's consider a scenario in fiscal year 2023. You earned a long-term capital gain of Rs 2,50,000 and a short-term capital gain of Rs 1,50,000. However, you experienced a capital loss of Rs 1,00,000 from another investment.
"Without tax harvesting, your tax liability would amount to Rs 37,500. However, by implementing tax harvesting, you can offset the capital loss against the gains, resulting in a reduced tax liability of Rs 22,500. This saves you Rs 15,000 in taxes. Here your tax liability is minimised," said CA Manish Mishra, Virtual CFO.
Tax harvesting is completely legal
According to Ashish Goel, Partner, Ved Jain and Associates, tax-loss harvesting is the process of selling underperforming securities such as shares, mutual funds etc. at loss in order to offset such loss with any gains which may have realized by the investors from sale of other investments. This is potentially a great tax planning tool for the investors who are looking to manage their tax liabilities and optimise their investments. This strategy though not defined under the Income Tax Act but the same is completely legal if done within the provisions of the Income Tax Act.
Understanding capital gains when holding equities and mutual funds
Under the Income Tax Act, investments held as listed shares, mutual funds etc. are treated as capital assets and gain or loss on the same are termed as capital gain /loss. In case listed shares and mutual funds are held for more than 12 months, then the gain or loss arising from sale of such assets will be treated as long-term capital gain otherwise the same will be treated as short-term capital gain/ loss. The long-term capital gain on such investments is exempt up to Rs. 1,00,000/- and any gain above Rs 1 lakh is taxed at 10 per cent. On the other hand, short term capital gain is taxed at the rate of 15%.
The short-term capital loss incurred can be adjusted with the long term/ short term capital gain earned during the year but the long-term capital loss can be adjusted with the long-term capital gain only and cannot be adjusted with short term capital gain.
"If an investor remains invested for multiple years then he can save the payment of tax on the gains made upto the limit of Rs 1 lakh at the time of redemption. Therefore, many investors sell stocks to book long term capital gain each year and reinvest the proceeds in the same stock and save tax on the profit of up to Rs 1 lakh," said Sandeep Bajaj, Managing Partner, PSL Advocates & Solicitors.
To reduce the tax liability on the short term/long term capital gains, the investor may choose following techniques of tax loss harvesting:
"In case the investor earns long term capital gain of more than Rs 1,00,000/-, the investor has both options to sell either loss-making long-term capital asset or loss-making short-term capital asset and adjust the long-term capital gain," said Goel.
Suppose an investor earns Rs. 3 lakh as long-term capital gains in a financial year. Thus, the applicable tax rate will be 10% in excess of threshold of Rs. 1,00,000/-. This makes LTCG tax at Rs. 20,000 on the net income of Rs. 2 lakhs If the investor has listed stocks or mutual fund units that have an unrealized loss of Rs. 70,000, he can go for tax harvesting as below.
Tax loss harvesting: By selling loss-making stocks or mutual fund units whether short term or long term, he/she can arrive at the net LTCG of Rs 1,30,000. The 10% tax will now be applicable on Rs. 1,30,000 and therefore the tax liability will be Rs. 13,000. Thus, the investor saves Rs. 7,000 in taxes.
b. In case of short-term capital gain, the investor can sell only loss-making short-term capital asset and adjust the short-term capital gain.
Example
Suppose an investor earns Rs 3 lakh as short-term capital gains in a financial year. This means he will be liable to pay 15% of the income as taxes. Thus, the STCG will be Rs 45,000. Let’s suppose that the investor also has short term capital asset in his portfolio that have an unrealized loss estimated at Rs 1,00,000. Then he can go for tax harvesting as below.
Tax loss harvesting: If investor sells these loss-making stocks, the net STCG goes down to Rs 2,00,000. Thus, the 15% tax will be applicable on Rs. 2.00,000, bringing down the tax liability to Rs. 30,000. The investor will save Rs. 15,000 in taxes. However, please note that this tax loss harvesting cannot be done by selling the loss-making long-term capital asset.
"The tax loss harvesting is one of the alternatives to making the investments in the residential properties or other tax saving investments for claiming the deduction section 54/ 54F etc. However, investors need to continuously watch his portfolio to reap out maximum benefit of this strategy," said Goel.
Sandeep Bajaj, Managing Partner, PSL Advocates & Solicitors explains this concept with another example:
X invests a sum of Rs 5,00,000 in equity in FY 2021-22. The value of such investment grows to Rs5,40,000/- in FY 2021-22, and to Rs 5,80,000/- in FY 2022-23 and finally Rs 6,20,000/- in FY 2023-24. If X were to sell the equity Stock in question in FY 2023-24, the capital gain upon such sale of Equity Stock would be Rs 1,20,000/- which exceeds the exemption limit by Rs 20,000/-. Therefore, X would be required to pay tax upon such sum of Rs 20,000/-. Now, if X were to sell this Equity Stock in FY 2022-23, the capital gain on such sale would be Rs.80,000/- only which is within the exemption limit. Thereafter, X can reinvest this amount of Rs 5,80,000/- in the same Equity Stock in FY 2023-24 thereby saving his tax liability.
Till the time the capital gain from sale of such Equity Stock in a particular Financial Year reaches an amount of Rs 1,00,000/- or more, X can keep reinvesting the sale proceeds in the same stock and save tax on the profit made up to Rs. 1,00,000/.
Is tax harvesting worth it?
"In any given year, the maximum tax that one can save is limited to 10 per cent (the LTCG tax rate) of Rs 1,00,000 (the exempt limit from the LTCG tax), i.e., Rs 10,000. Effectively, the total gains would be limited to this value multiplied by the total duration of your investment. Over a period of 25 years, for instance, the maximum possible savings would always be lower than or equal to Rs 2.5 lakh (Rs 10,000 multiplied by 25)," according to Value Research.
Moreover, in order to maintain continuity of investments, you will need to reinvest in equity funds as soon as you redeem the older units for tax-harvesting. "This will require you to maintain a fat balance in your bank account in order to make the buy transaction. After all, the redemption proceeds from the selling of units will be credited to your bank account only on the third day after the transaction. If an investor waits for these to be available for reinvestment, it could cause a significant opportunity loss should the NAV jump in the interim," said Value Research's Dhirendra Kumar.
While tax harvesting in direct equity and mutual funds also helps investors book profits and rebalance their portfolios yearly. retail investors need meticulous planning. "For example, while booking profits, the investor should immediately reinvest in the fund /stock. The mutual fund redemption takes up to three days. In the interim, if the fund NAV rises by 1%, it will will increase the cost of reinvestment. So, it is best to consult a tax professional or financial advisor to understand the tax impact in each case," said Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth.
While tax harvesting in direct equity and mutual funds also helps investors book profits and rebalance their portfolios yearly. retail investors need meticulous planning. "For example, while booking profits, the investor should immediately reinvest in the fund /stock. The mutual fund redemption takes up to three days. In the interim, if the fund NAV rises by 1%, it will will increase the cost of reinvestment. So, it is best to consult a tax professional or financial advisor to understand the tax impact in each case," said Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth.
