Tax harvesting is a strategic investment approach designed to optimise tax efficiency. By realising capital losses on specific investments, investors can offset capital gains, thereby reducing their overall tax liability. This technique is commonly employed to enhance the after-tax returns of an investment portfolio.
Prior to the 2018 tax reforms, long-term capital gains (LTCG) from equity investments were exempt from taxes. However, the subsequent introduction of LTCG tax, while providing a Rs. 1 lakh annual exemption, has presented a challenge for many investors. This exemption can only be utilized upon the realisation of capital gains through the sale of assets. Consequently, investors with substantial unrealised gains in their portfolios may struggle to fully benefit from this tax advantage.
What is tax harvesting?
Tax harvesting is a strategic approach to minimise tax liabilities by realising capital losses on underperforming investments to offset capital gains. Unused losses can be carried forward to future tax years, further reducing the overall tax burden and optimising the after-tax returns on an investment portfolio.
It is a simple two-step technique that can help investors maximise their after-tax returns. Let’s see how:
Step I: Sell investments at a loss
- When certain investments in your portfolio decline in value below their purchase price, they are considered to be in a "loss position."
- Tax loss harvesting involves intentionally selling these investments while they are in a loss position.
- This allows you to realise these losses for tax purposes.
Step II: Offset capital gains taxes
- Capital gains taxes are levied when you sell investments at a profit.
- However, by strategically selling investments at a loss, you can offset these capital gains taxes.
- The losses harvested from underperforming investments are used to offset the gains realised from the sale of other investments.
- This offset reduces the overall tax liability.
Also read: Short Term vs Long Term Capital Gains
Example of Tax Harvesting
Consider a scenario where Mr A has held two listed shares for more than 12 months. Recently, he checked his portfolio and realised that:
- Stock X, has declined in value since purchase, resulting in a loss of Rs. 10,000.
- Stock Y, has appreciated, generating a capital gain of Rs. 15,000.
Now, let’s see his overall tax liabilities with and without practising tax harvesting.
| Without tax harvesting | With tax harvesting |
| If Mr A sells Stock Y, he would be liable to pay capital gains taxes on the Rs. 15,000 gain.The overall long-term capital gain tax liability would be Rs. 1,500 (Rs. 15,000 x 10%)* | Mr A decided to sell Stock X to realise the Rs. 10,000 loss.The loss harvested from Stock X can be used to offset the capital gain from Stock Y.As a result, the taxable capital gain would be reduced to Rs. 500 (Rs. 15,000 (gain) - Rs. 10,000 (loss) x 10%* |
Observation -
It can be observed from the above example that tax harvesting effectively reduced the overall tax liability of Mr A by Rs. 1,000.
*As per the latest tax laws, the applicable capital gain tax rate on listed shares in India is decided as follows:
- When listed equity shares are held for 12 months or less than 12 months, the short-term capital gains are taxed at a rate of 15%.
- On the other hand, when the listed equity shares for held over 12 months, the long-term capital gains are taxed at a rate of 10%.
How tax-loss harvesting works?
Tax-loss harvesting, also referred to as tax-loss selling, is a strategic approach employed by investors to mitigate their tax burden. Typically implemented at year-end during portfolio performance reviews, this strategy involves selling underperforming investments to offset capital gains realised from other profitable assets.
By strategically utilising tax-loss harvesting, investors can substantially reduce their overall tax liability. For instance, the loss incurred on a specific security can be used to counterbalance the gains from another investment, thereby eliminating the associated capital gains tax. This proactive approach enables investors to optimise their after-tax returns and achieve significant tax savings.
Important points around tax harvesting
One common misconception about tax harvesting is that it's merely a way to reduce taxes in the short term. While it does offer immediate tax benefits by offsetting capital gains, its significance extends beyond just tax savings.
Tax loss harvesting plays a vital role in optimising investment portfolios for:
- Long-term growth and
- Tax efficiency
Selling underperforming investments allows investors to reallocate their capital into more promising opportunities. This reallocation further enhances the overall performance of the portfolios. Let’s understand this concept better through an example:
Initial investment
- Let us assume that you initially had an investment corpus of Rs. 1,00,000 and equally invested:
- Rs. 50,000 in Stock A and
- Rs. 50,000 in Stock B
Performance of investments
- After some time, you checked the performance of your investment and realised that:
- Stock A has decreased in value to Rs. 40,000, resulting in a loss of Rs. 10,000.
- Meanwhile, Stock B has appreciated to Rs. 70,000, resulting in a gain of Rs. 20,000.
Tax loss harvesting decision
- You decide to sell Stock A to realise the loss for tax purposes.
- After selling Stock A at Rs. 40,000, you realise a loss of Rs. 10,000.
- You now have Rs. 40,000 in cash from selling Stock A.
Reallocating capital
- You decided to reinvest the proceeds from selling Stock A into Stock B, which has been performing well.
New investment in Stock B
- With the Rs. 40,000 from selling Stock A, you increase your investment in Stock B to Rs. 90,000 (Initial investment of Rs. 50,000 + proceeds from selling Stock A of Rs. 40,000).
Re-allocated portfolio value
- After reallocating your capital, your portfolio consists of:
- Rs.10,000 from Stock A (loss realised for tax purposes) and
- Rs. 90,000 from Stock B.
Impact on portfolio performance
- By reallocating your capital from the underperforming Stock A to the high-performing Stock B, you:
- Enhanced the overall performance of your portfolio
- Capitalised on the strengths of Stock B's growth potential
- Minimised exposure to the underperforming Stock A.
- This way you will be able to maximise your investment returns and achieve tax efficiency.
Also read: Different types of investments
How can you practise tax loss harvesting?
Let us break this technique into easily digestible steps:
Step I: Identify investments in a loss position
- Review your investment portfolio to identify securities that have declined in value since purchase.
- These investments are considered to be in a "loss position" and are potential candidates for tax loss harvesting.
Step II: Sell investments at a loss
- Once you've identified investments in a loss position, decide which ones to sell for tax loss harvesting.
- Sell the selected investments to realise the losses for tax purposes.
Step III: Offset capital gains taxes
- Use the realised losses to offset any capital gains taxes incurred from the sale of other investments that have appreciated in value
- Subtract the realised losses from the capital gains to calculate the net taxable gain.
What is the wash sale rule?
Tax loss harvesting is subject to rules and limitations set by tax authorities. It must be noted that there are restrictions on ‘wash sales.’ This happens when you sell an underperforming capital asset at a loss and then repurchase the same within 30 days before or after the sale, then you are ineligible to claim the loss for tax purposes. This rule aims to prevent investors from artificially creating losses for tax benefits.
For example,
- You sold Stock A for a loss
- Within 30 days, you repurchased the same stock
- The loss realised on Stock A, will be disallowed for tax purposes.
- You won’t be able to reduce your capital gains from this realised loss.
Also read: What is direct tax code
How does tax harvesting apply to mutual funds?
Just like shares or stocks, you can do tax harvesting with your mutual fund holdings as well. Let us see an example to understand better:
You are holding mutual fund units in your portfolio of both
- Equity funds and
- Debt funds
One of the equity mutual funds, Fund Z, has underperformed compared to its benchmark index, resulting in a decline in value.
- You sold the units of Fund Z at a loss and used the realised loss to offset capital gains taxes from other investments, such as:
- Profitable equity funds or
- Individual stocks.
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Benefits of tax loss harvesting
Tax-loss harvesting offers several strategic advantages for taxpayers:
- Deferred tax liability: By strategically realising losses, taxpayers can postpone capital gains taxes. This can be particularly beneficial for long-term investment horizons, allowing for greater compounding potential.
- Optimised portfolio management: Tax-loss harvesting enables investors to maintain a diversified portfolio while minimizing tax burdens. By offsetting gains in higher-taxed asset classes with losses in lower-taxed ones, taxpayers can effectively reduce their overall tax liability.
- Maximised return potential: The ability to offset short-term capital gains with short-term losses can mitigate immediate tax implications. Moreover, by converting short-term positions into long-term ones, investors can benefit from lower long-term capital gains tax rates.
Key takeaways
- Tax-loss harvesting: A strategic investment technique employed to offset capital gains taxes by realizing losses on underperforming assets.
- Process: Involves selling assets at a net loss to reduce taxable income.
- Portfolio maintenance: Proceeds from these sales can be reinvested in similar assets to preserve overall portfolio composition.
Conclusion
Tax loss harvesting is a beneficial strategy for investors who are looking to reduce their tax liabilities. By selling an underperforming stock, a unit of a mutual fund, a bond, or any other capital asset, investors can utilise the realised losses to offset them with the capital gains earned on profitable capital assets.
However, this strategy must be exercised with caution keeping in mind the wash sale rule. The focus must be laid on not repurchasing the same investment within 30 days. By following tax loss harvesting, you can maximise tax savings and improve overall portfolio performance.
