Dear Qualified Financial Advisor,
I’ve been struggling with the returns I’ve earned on my equity shares and mutual funds. Each time I consider pulling out my equity-oriented investments, I’m hit by how much tax I would have to pay on this amount. With the new regulations, taxation on long-term capital gains is significant. At this point, it feels like a losing battle, but there’s a part of me that still wonders: is there a way for me to make the most of the returns on my investments while also paying taxes? How do I navigate this?
A Hopeful Investor.
Dear Hopeful Investor,
I hear you, and I’m reminded of something that Benjamin Franklin (that wise man on US dollar bills) once said — that nothing is certain, except death and taxes. While that’s certainly true about death, with proper planning, we can surely save on some taxes.
On 1 April 2018, life changed for many Indian investors in the equity market. This is when long-term capital gains (LTCG), on the sale of listed equity shares or equity-oriented mutual funds, were made taxable. Before this, investors had not been paying taxes on LTCG for nearly 15 years.
For the uninitiated, long-term — in the case of equity investing — means a holding period of more than 12 months from the date of purchase. When LTCG are over ₹1 lakh, they are taxable at the rate of 10%, plus a 4% cess, without the benefit of indexation.
Say, for example, in April 2020, you invested ₹6 lakh in listed shares and ₹3 lakh in equity-oriented mutual funds. In April 2022, the value of the shares is ₹4.5 lakh and the value of the mutual funds is ₹5 lakh. Given the gains you’ve made (₹2 lakh), you’d like to liquidate the mutual funds. Of this, ₹1 lakh is exempt, so you your LTCG tax is on the remaining ₹1 lakh. This means that you will have to pay 10%, plus the 4% cess, which equals ₹10,400.
On the other hand, if you have incurred a long-term capital loss on the sale of your shares or equity-oriented mutual fund units, you can set them off against any LTCG tax you may have to pay.
What was once a dead loss (prior to 31 March 2018) is now a boon for tax planners. So when you ask if there’s a way to navigate the amount of taxes you may have to pay on your long-term capital gains, I’m happy to say, yes! The tax on such profits can be cut down to some extent using a sophisticated tax-planning mechanism known as tax-loss harvesting.
Just like farmers harvest crops, when it comes to investing, tax-loss harvesting lets you collectively assess your taxes and offset your tax liability by selling of shares or mutual funds at a loss. Normally such investments are purchased again to maintain the same asset allocation or portfolio.
Let’s break this down using the same example as above. Even though you want to hold on to the shares for the long term, for the purpose of tax planning, you sell the shares you had invested in at ₹6 lakh and that are valued at ₹4.5 lakh. You can then re-invest the sale proceeds in the same shares within the next two to three days. This sale and reinvestment is a legal transaction and won’t have too much of an impact on your investment amount or returns generated. The long-term capital loss of ₹1.5 lakh on the sale of shares can then be set off against the LTCG of ₹2 lakh for the mutual funds. Since the balance LTCG is ₹50,000 — and less than ₹1 lakh — the amount is not taxable. This means that you will pay no tax!
What’s key to note is that there is no asset class restriction on the set-off. So losses in equities can be set off against gains in debt, real estate or gold. There are other nitty-gritties that come into play with tax-loss harvesting, which your financial advisor can help you with — but to answer your question, it’s safe to say that good tax planning can certainly help reduce the taxes you need to pay on LTCG.
1 Finance Advisory Committee for Qualified Financial Advisors — Mumbai Chapter.