During bull runs, investors cherish as asset prices rise in value. But, when the market dips, investors worry about their portfolios.
Of course, it’s not a pleasant thing to see your portfolio in red. But what if we say there’s a way to take advantage of those losses? It can be done through a technique called ‘Tax-Loss Harvesting.’
It is a technique that utilizes assets that have decreased in value to reduce your tax liability.
What Is Tax Loss Harvesting?
Tax-loss harvesting is a strategy that helps reduce taxes on your investments by selling assets that are not doing well. You can use your losses to offset taxes on investments that have generated profits.
Tax loss harvesting applies to equity, bond, real estate, and gold but not crypto. Unfortunately, Indian tax law doesn’t allow investors to harvest their tax loss for their crypto investments.
Well, how does tax loss really work? Before we tell you that, you must know a few basic terms as follows:
1. Capital gains
When you invest in equity, you can earn ‘capital gains.’
A capital gain is when you profit from selling your stocks for more than what you paid. For example, if you bought a stock for INR 800 and sold it for INR 1000, you made a capital gain of INR 200, which is taxable.
When investing in stocks, tax is levied on your profits based on your holding period. The holding period is the time between buying an investment and selling or transferring it.
- If you sell stocks for a profit within a year of the holding period, it’s called a Short-Term Capital Gain (STCG). STCGs are taxed at a rate of 15%, irrespective of your income tax slabs.
- In contrast, if you sell shares for a profit after a year, you make Long-Term Capital Gains (LTCG). It’s taxed at 10% (without indexation benefits) for gains over INR 1 lakh.
Indexation means that the value of an investment is adjusted for the effects of inflation over time. This adjustment is made using Consumer Price Index (CPI). It calculates the change in the value of an investment due to inflation.
Trivia: Before the 2018 budget, LTCGs made from selling equity shares or mutual funds were tax-free. That means you didn’t have to pay taxes on profits from long-term equity investments.
2. Capital loss
As you might have guessed, a capital loss is when you lose money from selling your stocks. For instance, if you bought a stock for INR 50 and sold it for INR 40, you made a capital loss of INR 10.
If you have incurred a loss within one year of the holding period, it’s called Short-Term Capital Loss (STCL). Likewise, when you experience a loss after one year, it’s called Long-Term Capital Loss (LTCL).
How Does Tax Loss Harvesting Function?
Now that we know the basics, let’s dive into the mechanism of tax loss harvesting.
Suppose you have made a profit and a loss from selling investments in the same tax year. In such scenarios, you can use the loss to reduce the tax you owe on the profit. This is how you harvest your losses to your advantage.
For example, if you have a short-term capital gain of INR 100,000, a long-term capital gain of INR 105,000, and a short-term capital loss of INR 50,000.
1. With tax-loss harvesting
Here, the short-term capital loss of INR 50,000 is used to offset the short-term capital gain of INR 100,000. Thus, the STCG tax applies only to (INR 100,000 – INR 50,000 =) INR 50,000. Overall, the tax payable would be INR 8,000, calculated as follows.
- 15% STCG Tax on INR 50,000 = INR 7,500
- 10% LTCG Tax on INR 5,000 = INR 500 (there is INR 1 Lakh tax exemption)
- Total Tax = INR 7,500 + INR 500 = INR 8,000
2. Without tax-loss harvesting
The tax payable would be INR 15,500 as the short-term capital loss isn’t utilized to offset the profits. It is calculated as follows.
- 15% STCG Tax on INR 100,000 = INR 15,000
- 10% LTCG Tax on INR 5,000 = INR 500 (there is INR 1 Lakh tax exemption)
- Total Tax = INR 15,000 + INR 500 = INR 15,500
Comparing the above cases, there is a reduction of (INR 15,500 – INR 8,000) INR 7,500 in tax burden through this method.
Please note short-term losses can offset both short-term and long-term gains. But the long-term losses can only be used to offset long-term gains.
You might ask — What if I cannot use the entire capital loss to my advantage in a given year? For instance, during the FY 2022/23, your short-term capital gain is INR 50,000, but your short-term capital loss is INR 300,000. It means there is an additional loss of INR 250,000 that can’t be used in this financial year.
There is good news for you. You can carry forward capital losses (both short and long-term) for the next eight assessment years (AY) if not fully used in the current year.
The assessment year is when the income earned in the previous financial year is calculated and taxed. For example, if the current financial year is 2022-23, the assessment year would be 2023-24.
Advantages of Tax Loss Harvesting
The most obvious advantage of tax-loss harvesting is that it helps to decrease your tax amount by offsetting income from capital gains.
But that’s not it –
- It also encourages you to sell your poor-performing assets and invest in return-generating assets.
- You can take advantage of market downturns by using the proceeds from tax-loss harvesting to buy other assets at a lower cost and diversify your portfolio.
- You can utilize the capital loss for the next eight assessment years. Thus, you can keep some of your losses and use them in future years as per your requirement.
Quick Tips Prior to Implementing Tax Loss Harvesting
When using tax-loss harvesting, remember the following:
- Long-term losses can only be used to offset long-term gains.
- Short-term losses can be used to offset both short-term and long-term gains.
- Tax loss harvesting should not be considered a primary investment strategy but a way to save on taxes.
- When investing the proceeds from selling loss-making assets, be cautious not to take too much risk to compensate for the losses.
Tax Loss Harvesting can be an effective strategy to reduce your overall tax burden. It is especially useful for people falling under the 30% tax bracket as they are already paying a hefty income tax.
In addition, this allows you to cut your losses and reinvest that amount in better-performing assets. Thus, when you identify a poorly performing asset, evaluate it to see the possibility of getting positive returns based on your desired time horizon. If the result isn’t in favor, book that loss and reinvest in a return-generating asset based on your goal and risk appetite.
1. How long do you have to wait for tax loss harvesting?
You can book gains and losses in your investments when the opportunity presents itself. The point is that short-term losses can offset both short-term and long-term gains. But long-term losses can only be used to offset long-term gains.
2. Is it better to harvest short-term or long-term losses?
It depends on your capital gains.
In India, the tax rate on short-term capital gains (STCG) is 15%, and the tax rate on long-term capital gains (LTCG) is 10% on gains above INR 1 lakh. It is generally better to harvest long-term losses if the gain is way above INR 1 lakh rupees. However, if the gain is less than INR 1 lakh rupees, it would be better to harvest short-term losses as there will be no tax.
It’s always good to consult with a financial advisor or a tax professional before deciding on harvesting losses, as it also depends on an individual’s overall tax situation and investment portfolio.
3. Is tax loss harvesting worth it in India?
Tax loss harvesting can be worth it in India if it helps to offset capital gains and reduce your overall tax liability. However, the value of tax loss harvesting may depend on an individual’s specific tax situation and investment portfolio.
Since India does not have a wash sale rule, you can repurchase the same stock or mutual fund you sold at a loss as soon as the trade is settled. You could buy back the shares with a minimal price difference and continue holding them if needed.
The wash sale rule is a US tax regulation that states, “An individual cannot claim a tax loss on the sale of a security if they repurchased the same or similar security within 30 days before or after the sale.” This rule is meant to prevent individuals from claiming tax losses for sales that are not genuine.