What is tax loss harvesting and how can it help you save taxes? MintGenie explains

As the tax-saving season nears its end, many taxpayers turn to tax-harvesting strategies to reduce their tax burden. For those unfamiliar, this approach involves selling investments that are currently at a loss (purchased at a higher price than their current value) to offset the capital gains taxes owed on profitable investments.

It’s widely recognized that investors generally aim to minimize their tax liabilities. While many individuals invest towards the end of the year for tax savings, there are alternative strategies to consider. In a fluctuating market, preserving your gains becomes a concern. Tax-loss harvesting allows you to sell investments at a loss to decrease your tax obligations, a tactic commonly employed by seasoned investors.

Tax-loss harvesting relies on having both capital gains and capital losses within your investment portfolio. Here’s the rationale behind this strategy:

• Tax-loss harvesting employs losses to counterbalance gains. To reap the tax-saving advantages of capital losses (losses from selling investments), you must have capital gains (profits from selling investments) in your portfolio.
• It reduces your tax liability. By balancing gains with losses, you effectively decrease the taxable amount, resulting in a reduced tax bill.

Thus, if the markets haven’t yielded any gains (all your holdings have either remained stable or increased), tax-loss harvesting would not be relevant for that particular year. Nonetheless, any unused capital losses can be carried forward to subsequent tax years to offset future capital gains.

Understanding how tax loss harvesting operates

Capital gains tax is levied on the profits earned from selling equity funds and stocks in India. The applicable tax rate is determined by the duration for which the investment was held before its sale, known as the holding period. Here is an explanation of how capital gains tax is applied to equity funds and stocks in India:

Long-term capital gains (LTCG): Applicable to investments held for over a year, a flat 10% tax is imposed on LTCG that exceeds Rs. 1 lakh in a financial year. It’s crucial to note that the indexation benefit, which accounts for inflation, does not apply to LTCG on equity funds and stocks. However, LTCGs up to ₹1 lakh in a financial year are exempt from taxation.

Short-term capital gains (STCG): Applicable to investments held for one year or less, STCG from equity funds and stocks are taxed at the individual’s income tax slab rate.

Most importantly, you can offset capital losses from the sale of equity funds or stocks against capital gains to minimize your tax liability.

How to benefit from tax-loss harvesting?

Review your stock or equity fund portfolio to pinpoint individual holdings with unrealized losses. Many brokers/platforms offer this information readily available. Identify holdings with the greatest absolute losses and consider selling them before March 31.

If you’re selling only a portion of your holdings, utilize the First In, First Out (FIFO) method. When you sell a portion of your shares from a specific investment using the FIFO method, it assumes that the shares you sell are the ones you acquired first. This can impact the capital loss you report on your taxes.

Increased losses: If the stock price has been consistently decreasing, the shares you’re selling (the ones you purchased first) will probably have a higher purchase price than the current market value, leading to a larger capital loss.

Reduced losses: On the other hand, if the stock price has varied but is ultimately higher than your initial purchase price, using the FIFO method could result in selling shares acquired at a higher cost, resulting in a smaller capital loss or possibly even a capital gain.

Short-term vs long-term capital losses

When engaging in tax-loss harvesting, it’s essential to distinguish between short-term and long-term capital losses to maximize tax benefits. Here’s how to recognize and strategically sell for enhanced tax advantages:

Holding period: The crucial determinant is the duration for which the investment is held. Securities sold within one year of purchase lead to a short-term capital loss. In contrast, investments held for over a year result in long-term capital losses.

Focus on short-term losses: Short-term capital losses offer greater flexibility as they can offset both short-term and long-term capital gains. Therefore, if you have capital gains to counterbalance, start by selling assets with short-term losses.

Align long-term losses with long-term gains: Long-term capital losses can solely offset long-term capital gains. Hence, aim to sell assets with long-term losses up to the value of your long-term capital gains. This strategy ensures you capitalize on the lower tax rate for long-term capital gains.

Offsetting gains with capital losses

Your capital gains report might also display any carried forward capital losses from prior years. These are unused losses that can be applied to future tax years to offset capital gains, potentially lowering your tax liability. By examining your capital gains report and taking into account any capital losses carried forward, you can:

• Decide whether you should sell any investments at a loss to counterbalance capital gains and minimize your tax obligation.
• Make educated investment choices to effectively manage your total tax liability.

How to access your capital gains report?

You can obtain your capital gains report from your broker or investment platform. This report usually details your overall capital gains, encompassing both short-term capital gains and long-term capital gains, after accounting for any applicable tax benefits such as grandfathering and concessions. Reviewing this report can assist you in identifying the capital losses you might need to realize to counterbalance gains and potentially lower your tax obligation. Here’s a guide to help you understand what to look for in your capital gains report:

Total capital gains: This represents the total amount of capital gains you earned from selling investments within the fiscal year.

Long-term capital gains: These are profits from selling investments held for over one year. Depending on your tax bracket and the nature of the investment, LTCGs might qualify for lower tax rates or exemptions.

Short-term capital gains: These are profits from selling investments held for under one year. Typically, STCGs are taxed at a higher rate compared to LTCGs.

Having a long-term outlook

Typically, bear markets present opportune moments to buy rather than sell equities. If you’ve sold a substantial portion of your equity portfolio for tax-loss harvesting, ensure you promptly replenish your portfolio to maintain your equity allocation.

After conducting tax-loss harvesting by selling investments at a loss, an essential step is to reinvest in similar assets to preserve your long-term investment strategy.

Identify repurchase candidates: From the investments you sold for tax-loss harvesting, concentrate on those you originally planned to hold for the long term.

Wait for settlement: The funds from your sales might not be instantly available due to settlement periods. Consider this delay before making repurchases.

Target comparable investments: Strive to repurchase investments that are similar to the ones you sold, but not identical. This helps prevent violating the wash-sale rule, which prohibits tax deductions if you buy back the same or substantially identical security within 30 days of selling it at a loss.

Price matching: Ideally, aim to repurchase at a price near to or below your selling price to optimize your long-term returns.

When reinvesting after tax-loss harvesting, you don’t need to repurchase the exact same stocks or funds you sold. This is to prevent violating the wash-sale rule, which prohibits claiming capital loss deductions if you buy back the same security within 30 days of selling it at a loss.