Rohit had a diverse investment portfolio in 2023. By December, he realised he had the following capital gains and losses:
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- Loss of Rs 1 lakh on sale of equity shares of XYZ Ltd (held for 2 years)
- Gain of Rs 2 lakhs on sale of debt mutual funds (held for 1 year)
- Gain of Rs 80,000 on sale of real estate property (held for 5 years)
As per income tax rules, long-term capital losses can be set off against any long-term capital gains in the same year.
So Rohit, very strategically, decided to reduce his tax liability for 2023. Here’s what he did:
- He booked the Rs 1 lakh loss by selling the XYZ shares, on which he had a long-term loss.
- He adjusted this Rs 1 lakh loss against the long-term capital gain from the debt funds.
- After setting off, the net long-term capital gain was Rs 1 lakh (Rs 2 lakhs – Rs 1 lakh).
- Short-term capital losses can be adjusted against both short-term and long-term gains.
By capitalising on the tax loss of Rs 1 lakh on XYZ shares, Rohit reduced his total taxable capital gains for 2022 to only Rs 80,000. This resulted in lowering his income tax liability for the year.
What you just read is a classic example of Tax Harvesting!
Tax-loss harvesting refers to the strategy of selling securities (equities, bonds, etc) purposely at a loss to offset capital gains (profit made on sell of properties, securities etc) to reduce tax liability.
At its core, it uses some specific provisions in tax laws that allow adjusting capital losses against gains.
Common forms of tax-loss harvesting in India
Tax-loss harvesting takes various forms in India, with some more straightforward than others.
Selling loss-making stocks:
The simplest form of tax-loss harvesting involves selling stocks on which there are losses, also called loser stocks. By booking the capital losses, they can be adjusted against capital gains from other securities to lower the tax liability. Stocks are normally sold towards the end of the financial year to crystalize losses for claiming tax benefits.
Booking losses in mutual funds:
Tax-loss harvesting can also be done by switching between mutual fund schemes or plans within the same fund house. This involves shifting from one scheme with long-term loss to another direct scheme to realise losses, which can then be adjusted.
Wash sales:
Wash sales means selling a stock or mutual fund at a loss and immediately buying it back. By doing so, the investor books the loss for taxation purposes but remains invested.
While simpler strategies are usually acceptable, complex loss harvesting plans could raise questions on intention and purpose.
The line between prudent tax planning and unethical tax avoidance is often blurred
Income Tax rules applicable in India
Tax-loss harvesting in India needs to be implemented within the boundaries set by income tax laws. Some key rules are:
Section 112A
Section 112A governs Long-Term Capital Gains (LTCG). If the LTCG is more than Rs. 1 lakh from the sale of listed equity shares, equity-oriented mutual funds, or units of a business trust, it incurs a 10% tax without indexation benefits. This tax only applies if the securities transaction tax (STT) was paid during both the transfer and acquisition in specific scenarios.
Section 111A
Section 111A of the Income Tax Act, 1961 focuses on Short-Term Capital Gains (STCG). Here, gains from transferring capital assets held for 36 months or less are considered. The tax rate for STCG is based on the individual’s tax slab.
For listed equity shares, equity-oriented mutual funds, or units of a business trust, if STT was paid during the transfer, the gains are taxed at 15%. However, if STT wasn’t paid at the transfer, the gains are taxed based on the individual’s applicable income tax slab rate.
Tax-loss harvesting, therefore, becomes a relevant strategy primarily for assets that do not enjoy this exemption, such as debt funds and debt securities, where any capital gains can be set off against capital losses to reduce the tax liability.
Section 70 – Set off of losses from one source against another:
Section 70 of the Income Tax Act, 1961, plays an important role in the set-off of losses from one source against income from another, within the same head of income.
This provision is particularly important in the context of tax planning and tax-loss harvesting strategies. Here’s a detailed look at how this works, especially concerning capital gains and losses:
Same Head of Income: Losses from one source can be set off against income from another source within the same head of income.
Capital Losses: Short-term capital losses can be set off against both short-term and long-term capital gains. Long-term capital losses can only be set off against long-term capital gains.
Against other heads of income : Specific Restrictions: Some losses, like speculation losses, are only set off against specific types of income, e.g., speculative profits.
Non-speculative Business Losses: Can be adjusted against any income except salary.
Carry Forward Rules: Unadjusted losses can be carried forward to subsequent years, with capital losses being carried forward for up to eight years.
Section 73-74 – Loss carry forward provisions:
These sections allow individuals to carry forward capital losses for up to 8 assessment years to offset future capital gains. This essentially extends the time frame for benefiting from tax advantages.
For instance, let’s say you incur capital losses from selling certain investments. Instead of losing the benefit of these losses in the current year, you can carry them forward for up to 8 years. When you eventually make capital gains in the future, you can utilise these carried-forward losses to reduce your tax liability.
To wrap up
Tax-loss harvesting is a legal and commonly used practice in India to manage tax liabilities. Nonetheless, it’s important to exercise this strategy responsibly, as any misuse could lead to penalties.
