What is Tax Loss Harvesting and How Does it Work?

Investments in equity mutual funds and stocks have now become very popular. Where previously such investments were not very common, now, with the advent of technology, the ability to buy and sell mutual funds and stocks on smartphones has become as easy as ever. Hence, millions of Indians have turned to mutual funds and stock market investing to grow their money.But as we all know, investing in equity markets is a risky affair since the value of the stock or mutual fund unit can nosedive with great unpredictability. Market trends are random, and nobody can really predict how the market will behave.During such a time when an investment you made in the equity market is not performing as well as you expected, there is no need to lose all hope. With tax loss harvesting , you can make the most of your under performing assets and use them to reduce your capital gains tax liability.

When we invest in the equity market, either via the purchase of mutual fund units or by purchasing stocks, we can either make capital gains or capital losses on our investments. Based on the duration of time we remain invested, these gains or losses can be termed as Long Term Capital Gains/Losses or Short Term Capital Gains/Losses.Now the capital gains that you make via equity investments are taxable. Short Term Capital Gains (STCG) are taxed at 15%, while Long Term Capital Gains (LTCG) above Rs. 1 lakh annually are taxed at 10% without indexation.Thus, whenever you earn returns on your short or long term equity investments, you have to pay the applicable tax as mentioned above.But here comes an important point. If your portfolio is diverse, then you might have some investments where you’ve incurred losses. The government allows you to set off these capital losses against the capital gains you made when calculating your tax liability. Thus, instead of taxing your capital gains directly, you can reduce your net gains by factoring in the losses you faced as well.For example, let’s assume you made short term capital gains of Rs. 50,000 on your equity investments, but on the other hand, you also incurred short term capital losses of Rs. 20,000. Thus, in this case, you need not pay STCG for Rs. 50,000 but for the net profit of Rs. 50,000-Rs. 20,000 which is Rs. 30,000.You can use this benefit to your advantage and reduce your tax outgo. Tax loss harvesting is essentially selling off the equity assets that you feel are underperforming. You obviously incur a loss when you sell these assets. But these very losses can be used to offset the capital gains in your other investments and lower capital gains tax.

Basically, tax loss harvesting is when you sell off an underperforming equity asset at a loss and use this loss to offset the capital gains on other well-performing assets, essentially reducing your capital gains tax liability.Let's understand this with an example:Rohit has a diverse investment portfolio that includes equity mutual funds as well as stocks. Let's suppose that, for a particular financial year, Rohit’s capital gains were as follows:Long Term Capital Gains = Rs. 150,000Short Term Capital Gains = Rs. 80,000Thus, Rohit’s capital gains tax liability will be as follows: STCGT = 80000 x 15% = Rs. 12,000 LTCGT = (150000-100000) x 10% = Rs. 5000Thus, Rohit’s total tax liability would be Rs. 12000 + Rs. 5000 = Rs. 17000.Now, Rohit has a look at some of his other equity investments and finds that these stocks are underperforming and have no chance of recovery. He decides to benefit from tax loss harvesting and sells these stocks at a loss of Rs. 30,000 as short term capital loss. He then invests those funds in other better performing stocks.His new tax liability now becomes: STCGT = (80000-30000) x 15% = Rs. 7500 LTCGT = Rs. 5000Total Capital Gains Tax = Rs. 12,500Thus, we can see that with tax loss harvesting, Rohit was able to save Rs. 3500 in capital gains tax. Additionally, since he has invested the capital from the sold assets in other stocks, he stands to recover the losses if the stocks perform well.

There are other ways by which you can reduce your tax outgo, especially if you’re running a business. The tax laws allow you to deduct your business related expenses from your taxable income. Let's look at some business related expenses that are eligible to be deducted:

• Internet bills
• Telephone bills
• Brokerage charges
• Rent paid if the rented place is used for the business itself
• Salary or consultation fees for employees

Now that we know that tax loss harvesting can be done to offset an investment loss by reducing taxes, do note that this is something you must do only after understanding all associated factors. Here are some things to keep in mind before you opt for tax loss harvesting:

• Tax loss harvesting always involves selling your assets at a loss. There is no guarantee that you will recover your losses if you invest in other assets.
• You can only offset long term capital losses against long term capital gains. Short term capital losses, on the other hand, can be set off against both long and short term gains.
• Use tax loss harvesting only as a tax saving strategy and not as an investment strategy.
• Ensure you calculate your tax liability accurately before selling your assets for a loss.

Tax loss harvesting is a great way to make use of your losses in equity investments and turn them to your advantage by reducing your capital gains tax liability. The next time you see an equity asset that can no longer recover, opt for tax loss harvesting as a damage reducing strategy.Ready to make the most of your money? Start your tax planning journey now!

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.