How tax-loss harvesting on investments can minimise your capital gains tax outflows

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In the 2018 budget, the long-term capital gains (LTCG) tax on equity was introduced. Since then, investors have had to keep in mind the tax implications of their decisions while entering and exiting equity instruments such as stocks and mutual funds, even after a year. There is a sophisticated tax optimization strategy often used by high net-worth individuals in developed markets – tax loss harvesting. Indian investors can also explore this method to reduce the tax liability on their realized capital gains.

Basics of tax loss harvesting

Let us say you have a portfolio of stocks and debt mutual funds. Let us assume that you carried out transactions through the year on the debt funds that led to some capital gains. Normally you would pay taxes on these capital gains in each year as they materialize.

Tax-loss harvesting attempts to minimize your capital gains tax payment – by gainfully exploiting the volatility of equities. It is aimed at reducing the overall tax outflow, and also pushing it forward in time. In the above example, tax loss harvesting would work as follows.

-In the current year, calculate your unrealized capital gains and losses in each stock.

-Single out stocks in which you have unrealized capital losses. Sell these stocks and buy them again after 2 days (assuming a T+2 settlement).

-You now have capital losses to set off against your capital gains in the current year.

What about the tax increase later from the low purchase price?

One may wonder what the point of this exercise is if the eventual capital gains increase by the same amount as the current year capital loss harvested. For example, let’s say you buy a stock at Rs 100 and it goes to Rs 80. You can book the capital loss of Rs 20. However, if and when the stock goes up to, say, Rs 115, your capital gains are now Rs 35 – as against what they could have been if you didn’t book the losses in the interim. This may make tax loss harvesting look like a net-zero-benefit activity.

However, there are three distinct benefits to tax loss harvesting.

-Time value benefit

-Cross asset benefit

-Short-term versus long-term tax rate benefit

These partly depend on the nature of set-offs allowed, summarized in the following table.

There is no asset class restriction on the set off. Hence losses in equities can be set off against gains in debt, real estate or gold.

Time value benefit

Most of us have investments that have no concrete exit planned. Also new investments keep getting added each year. Realistically, our holdings can be thought of as fairly long term – often spanning over 10 years. If you can postpone your tax liability to a later year, you already benefit from the time value of the savings.

If you pay Rs 100 in taxes in year 10 versus in year one, you have already saved nearly 50 percent in terms of the time value of money (assuming a 7 percent discount rate).

Cross asset benefit

Short term capital gains tax on equities is 15 percent, while that on other asset classes is the slab rate (33 percent to 42 percent for most investors). Hence, you are able to set off losses from a lower tax asset class against gains in higher tax asset class.

Say, you invested in long term debt mutual funds and that strategy played out well (as it has in recent years). Now you would like to move away from duration strategy because interest rates have bottomed out. If you had been holding the gilt funds for less than three years, you will pay tax at marginal rate (say 35 percent) on the gains. However, if you had used tax loss harvesting through 2020, you would have enough short-term capital loss in equities to set off against these gains.

Your future tax liability on equities may go up, but that will be taxed at 10 percent – which is much lower than 35 percent!

Short term vs long term benefit

Say you got some calls right on sectoral recovery amongst stocks. Now you would like to exit these. Let us say some other calls of yours are still playing out and are currently in short term loss. You may harvest short term capital losses in the latter and set off the gains against these. If these stocks eventually go up, you will have a tax liability but that will be only at 10 percent if the holding period crosses a year.

How to implement a well-defined tax loss harvesting strategy

To implement a coherent tax loss harvesting strategy, one needs to keep in mind the following.

-The transaction cost of selling and buying a given stock should be kept in mind. In general, short term loss of at least 5percent and long-term loss of at least 10percent is needed to justify the transaction cost vs savings in taxes.

-Amount of tax loss needed in a year is a function of the realized capital gains in that year. It is not advisable to book excessive long term capital losses just to carry them forward. However, short term capital losses are fine to be booked even for carrying forward because these are typically harder to come by and are far more beneficial for set-offs.

-Tax calculations work on a First-In-First-Out (FIFO) basis. This may split booked tax losses into long term and short term in most cases.

-It is advisable to track the unrealized capital loss values, if any, from time to time instead of trying it only once at the end of the financial year.