- Date : 03/09/2021
- Read: 7 mins
Tax loss harvesting is a strategy that investors are legally allowed to adopt to reduce their tax liability from selling an investment at a loss, and using this capital loss to offset any taxable capital gains made on equity.
The inevitable up and down movements of stock exchange indices mean there are times when even the smartest of investors get punished. However, these investors also know that despite occasional setbacks, losers among them can become winners – because the income tax laws allow them to capitalise on a benefit known as tax loss harvesting.
What is tax loss harvesting?
Tax loss harvesting is a strategy that investors are legally allowed to adopt to reduce their tax liability from selling an investment (listed stocks or fund units) at a loss, and using this capital loss to offset any taxable capital gains made on equity. (When an investment is sold at a loss, the loss is said to have been ‘booked’).
Investors in the US typically employ this strategy to limit the tax liabilities of short-term capital gains (STCG), which usually attract higher federal income tax rates than long-term capital gains (LTCG). However, the strategy is also often pursued for offsetting LTCG when needed.
Similarly, in India, investors resort to this strategy for STCG as the tax rates on such gains are higher than that of LTCG: 15% for STCG while LTCG were non-taxable prior to April 1, 2018, and from that date, an LTCG tax of 10%, without the benefit of indexation, for gains of more than Rs 1 lakh on equity funds and shares.
This change in tax norms for LTCG came following an amendment proposed in the annual budget for 2018-19. Since then, the tax loss harvesting strategy has also become popular for LTCG on the sale of equity shares.
Set-offs in tax loss harvesting
There are two issues to be understood for the purpose of tax loss harvesting: setting off losses and carrying them forward. Set-offs and carry forwards are two means sanctioned by India’s income tax laws to help taxpayers take advantage of losses they have incurred.
Set-off means adjusting losses against profit or income made in a particular year, and it can be in the form of an intra-head set-off or an inter-head set-off. So, under the income tax laws, loss in speculative business can only be set off against some other speculative activity. Similarly, loss under the head capital gains can be set off only within the ‘Capital Gains’ head; it cannot be set off against income from any other heads.
There is no asset class restriction on the set-off under capital gains. This means that losses in equities can be set off against gains in other investments, such as debt funds, gold or even real estate. However, there is a twist elsewhere: while short-term capital losses can be set off against either LTCG or STCG, long-term capital losses can be set off only against LTCG and not against STCG.
The second point to understand relates to carrying forward losses. Under this concession, if the entire capital loss cannot be set off in a single financial year, the law allows for both short-term and long-term loss to be carried forward for eight assessment years immediately following the assessment year of the loss.
Related: You can save tax with tax loss harvesting! Here’s how
How tax loss harvesting works
As stated earlier, tax loss harvesting can be used for both STCG and LTCG. We will explore how it works for both, starting with a hypothetical case for the former.
- For short-term capital gains
STCG tax comes into play if your holding period is less than 12 months. The impact of this tax can be lessened by booking any loss in other funds over the short term to offset the gains by an equivalent amount. For example, let us assume that the short-term gains of an investor are Rs 40,000 in a financial year. Under India’s income tax laws, the STCG tax liability is 15% of that, or Rs 6000.
However, if this investor has also incurred short-term losses of Rs 20,000 in some other funds in the same period, this loss can be booked against the gains, in which case the tax commitment drops to Rs 3000 (15% of Rs 40,000 gains less Rs 20,000 loss). This taxation rule holds true for all types of listed mutual fund schemes and stocks.
- For long-term capital gains
LTCG norms come into play if the holding period is more than 12 months for equity funds and shares, with long-term capital gains exceeding Rs 1 lakh attracting a 10% LTCG tax. Here too, as in the case cited earlier, the tax harvesting process can be used to reduce the tax liability.
Imagine an investor put in Rs 3 lakh in stocks or an equity fund on 1 January 2020, and found the investment value of their holdings to have dropped to Rs 2.70 lakh, reflecting a long-term capital loss of Rs 30,000. Let us now assume this investor failed to book the losses in 2021, but they can still go for tax loss harvesting later against any future gains within 2008.
For instance, if this person sells a long-term equity fund two years later and makes capital gains of Rs 2 lakh – i.e. over the threshold of Rs 1 lakh – they have to pay tax. However, by booking the loss of Rs 30,000 from 2020 against the gain for tax calculation, the effective LTCG will come down to Rs 1,70,000, as against capital gains of Rs 2 lakh.
Does tax loss harvesting make sense?
As with almost everything in life, there are two sides to tax loss harvesting. First, there is the benefit of minimising one’s capital gains tax outflows. Then there is the opinion of master investor Warren Buffett, who feels investors should think twice before selling a losing investment.
Buffett, who is the Chairman and CEO of Berkshire Hathaway, feels the strategy could end with the investor selling a good stock with strong fundamentals just because it made losses one year. In a letter to his shareholders in 1965, he wrote: “What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound.”
But backers of tax loss harvesting say the strategy has three distinct benefits:
- Time value benefit
- Cross asset benefit
- Short-term versus long-term tax rate benefit
Let us start with the first – time value benefit. Advocates of the tax loss harvesting strategy say most investors do not have any concrete exit planned, with their holdings often spanning over a decade. So, if a tax liability is deferred to a later year, the investor benefits from the time value of the savings.
To these advocates, the cross asset benefit becomes evident with short term capital gains. STCG tax on equities is 15%, as against the slab rates (33%-42%) for other asset classes for most investors. This means losses from a lower tax asset class can be set off against gains in higher tax asset class.
Finally, they weigh short-term benefits against long-term ones. This point is this: If loss-making stocks eventually go up, the investor will have a tax liability of only 10%, assuming the holding period is more than a year.
Related: Looking for ways to save tax on Long-Term Capital Gains? Here are some solutions
Last words
In the end, it is advisable to remember that a tax loss harvesting strategy works if it is coherent. To achieve this, financial advisors say a few points need to be kept in mind:
First, short term loss must be at least 5% and long-term loss at least 10% to justify the selling losing investments. Second, though short-term capital losses make sense in set-offs, it is inadvisable to book excessive long-term capital losses just to carry them forward. And finally, unrealised capital losses should be tracked on a regular basis instead of only once, towards the financial year-end.
The inevitable up and down movements of stock exchange indices mean there are times when even the smartest of investors get punished. However, these investors also know that despite occasional setbacks, losers among them can become winners – because the income tax laws allow them to capitalise on a benefit known as tax loss harvesting.
What is tax loss harvesting?
Tax loss harvesting is a strategy that investors are legally allowed to adopt to reduce their tax liability from selling an investment (listed stocks or fund units) at a loss, and using this capital loss to offset any taxable capital gains made on equity. (When an investment is sold at a loss, the loss is said to have been ‘booked’).
Investors in the US typically employ this strategy to limit the tax liabilities of short-term capital gains (STCG), which usually attract higher federal income tax rates than long-term capital gains (LTCG). However, the strategy is also often pursued for offsetting LTCG when needed.
Similarly, in India, investors resort to this strategy for STCG as the tax rates on such gains are higher than that of LTCG: 15% for STCG while LTCG were non-taxable prior to April 1, 2018, and from that date, an LTCG tax of 10%, without the benefit of indexation, for gains of more than Rs 1 lakh on equity funds and shares.
This change in tax norms for LTCG came following an amendment proposed in the annual budget for 2018-19. Since then, the tax loss harvesting strategy has also become popular for LTCG on the sale of equity shares.
Set-offs in tax loss harvesting
There are two issues to be understood for the purpose of tax loss harvesting: setting off losses and carrying them forward. Set-offs and carry forwards are two means sanctioned by India’s income tax laws to help taxpayers take advantage of losses they have incurred.
Set-off means adjusting losses against profit or income made in a particular year, and it can be in the form of an intra-head set-off or an inter-head set-off. So, under the income tax laws, loss in speculative business can only be set off against some other speculative activity. Similarly, loss under the head capital gains can be set off only within the ‘Capital Gains’ head; it cannot be set off against income from any other heads.
There is no asset class restriction on the set-off under capital gains. This means that losses in equities can be set off against gains in other investments, such as debt funds, gold or even real estate. However, there is a twist elsewhere: while short-term capital losses can be set off against either LTCG or STCG, long-term capital losses can be set off only against LTCG and not against STCG.
The second point to understand relates to carrying forward losses. Under this concession, if the entire capital loss cannot be set off in a single financial year, the law allows for both short-term and long-term loss to be carried forward for eight assessment years immediately following the assessment year of the loss.
Related: You can save tax with tax loss harvesting! Here’s how
How tax loss harvesting works
As stated earlier, tax loss harvesting can be used for both STCG and LTCG. We will explore how it works for both, starting with a hypothetical case for the former.
- For short-term capital gains
STCG tax comes into play if your holding period is less than 12 months. The impact of this tax can be lessened by booking any loss in other funds over the short term to offset the gains by an equivalent amount. For example, let us assume that the short-term gains of an investor are Rs 40,000 in a financial year. Under India’s income tax laws, the STCG tax liability is 15% of that, or Rs 6000.
However, if this investor has also incurred short-term losses of Rs 20,000 in some other funds in the same period, this loss can be booked against the gains, in which case the tax commitment drops to Rs 3000 (15% of Rs 40,000 gains less Rs 20,000 loss). This taxation rule holds true for all types of listed mutual fund schemes and stocks.
- For long-term capital gains
LTCG norms come into play if the holding period is more than 12 months for equity funds and shares, with long-term capital gains exceeding Rs 1 lakh attracting a 10% LTCG tax. Here too, as in the case cited earlier, the tax harvesting process can be used to reduce the tax liability.
Imagine an investor put in Rs 3 lakh in stocks or an equity fund on 1 January 2020, and found the investment value of their holdings to have dropped to Rs 2.70 lakh, reflecting a long-term capital loss of Rs 30,000. Let us now assume this investor failed to book the losses in 2021, but they can still go for tax loss harvesting later against any future gains within 2008.
For instance, if this person sells a long-term equity fund two years later and makes capital gains of Rs 2 lakh – i.e. over the threshold of Rs 1 lakh – they have to pay tax. However, by booking the loss of Rs 30,000 from 2020 against the gain for tax calculation, the effective LTCG will come down to Rs 1,70,000, as against capital gains of Rs 2 lakh.
Does tax loss harvesting make sense?
As with almost everything in life, there are two sides to tax loss harvesting. First, there is the benefit of minimising one’s capital gains tax outflows. Then there is the opinion of master investor Warren Buffett, who feels investors should think twice before selling a losing investment.
Buffett, who is the Chairman and CEO of Berkshire Hathaway, feels the strategy could end with the investor selling a good stock with strong fundamentals just because it made losses one year. In a letter to his shareholders in 1965, he wrote: “What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound.”
But backers of tax loss harvesting say the strategy has three distinct benefits:
- Time value benefit
- Cross asset benefit
- Short-term versus long-term tax rate benefit
Let us start with the first – time value benefit. Advocates of the tax loss harvesting strategy say most investors do not have any concrete exit planned, with their holdings often spanning over a decade. So, if a tax liability is deferred to a later year, the investor benefits from the time value of the savings.
To these advocates, the cross asset benefit becomes evident with short term capital gains. STCG tax on equities is 15%, as against the slab rates (33%-42%) for other asset classes for most investors. This means losses from a lower tax asset class can be set off against gains in higher tax asset class.
Finally, they weigh short-term benefits against long-term ones. This point is this: If loss-making stocks eventually go up, the investor will have a tax liability of only 10%, assuming the holding period is more than a year.
Related: Looking for ways to save tax on Long-Term Capital Gains? Here are some solutions
Last words
In the end, it is advisable to remember that a tax loss harvesting strategy works if it is coherent. To achieve this, financial advisors say a few points need to be kept in mind:
First, short term loss must be at least 5% and long-term loss at least 10% to justify the selling losing investments. Second, though short-term capital losses make sense in set-offs, it is inadvisable to book excessive long-term capital losses just to carry them forward. And finally, unrealised capital losses should be tracked on a regular basis instead of only once, towards the financial year-end.
