When it comes to taxes in India, most people only think about taxes on their salary or business income. Most people are aware of the tax slabs and exemptions, but what about taxes on investments?
It's easy to overlook the taxes on capital gains made on your investments because they are not deducted at source like a tax on salary. This means that you need to manage your investments and calculate your tax liability actively or you might end up paying more taxes than necessary.
This is where tax harvesting comes in. By selling off your losing stock investments or mutual funds, you can offset your gains and reduce your tax liability. This strategy can be especially useful for investors who have made significant gains from their investments.
Capital assets and Capital gains
Capital assets are assets that one holds for investment or productive purposes including land, buildings, house property, stocks, jewellery, etc. Capital gains tax in India is applicable on the profit made from the sale of a capital asset.
In this article, we will only discuss capital gains taxes on equity or preference shares, debentures, government securities, bonds, and mutual funds.
Based on the duration of holding the asset, the capital gains tax is categorised into two.
1.Long-term capital gains (LTCG)tax is applicable on investments sold after 12 months of purchase. Investors have to pay 10% of the profits exceeding ₹1 lakh as LTCG tax.
For example, you have invested ₹5 lakhs in a stock. After 2 years, the value of your investment reaches ₹6.5 lakhs. This means you made a long-term capital gain of ₹1.5 lakhs. If you sell your investment and book your profit at this time, you will pay taxes on the gains exceeding 1 lakh i.e. ₹50,000. You will have to pay ₹5,000 (10% of ₹50,000) as LTCG tax on this investment.
2.Short-term capital gains (STCG) tax is applicable on investments sold within 12 months of purchase. Investors have to pay 15% of the profits as STCG, irrespective of the amount of profit.
For example, you invested ₹1 lakh in a stock on 30 April 2023. If you sold your holdings on 31 December 2023 for ₹1.5 lakhs, you will have to pay a flat 15% tax on the gain of ₹50,000 i.e. you will pay ₹7,500 as STCG tax.
Two ways to reduce your LTCG tax liability
1. Sell before gains exceed > ₹1 lakh: Since long-term capital gains below ₹1 lakh are tax-free, investors can monitor their gains and sell the investment before the gains exceed ₹1 lakh. For example, you invested ₹5 lakhs in January 2022. In March 2023, your investment value is ₹5.6 lakhs. Now you can sell & book a gain of ₹60,000 & pay ₹0 LTCG tax since gains are less than ₹1 lakh.
What happens if LTCG exceeds ₹1 lakh?
Suppose you don’t book your profits and your investment value reaches ₹7 lakhs by the next year. Your long-term capital gains are ₹2 lakhs ( ₹7 - ₹5 lakhs) instead of ₹60,000. Now the gains exceeding 1 lakh are 1 lakh. Hence, you end up paying 10% of ₹1 lakh i.e. ₹10,000 as tax.
2. Offsetting losses with gains: Tax-loss harvesting is a strategy used to reduce tax liability on stock returns by offsetting losses with gains.
Suppose you invested ₹1 lakh in a stock in 2021. By 2023 if your investment has reduced to ₹80,000, you’ve incurred a loss of ₹20,000 so far. This is a long-term capital loss since you invested more than 12 months ago. Now if you think that the stock may not recover, you can book the loss of ₹20,000 by selling the investment.
Meanwhile, suppose one of your other investments has a long-term capital gain of ₹1.5 lakhs. If you book the profit, you pay a 10% tax on ₹50,000 (amount exceeding ₹1 lakh).
You can offset the long-term capital loss of ₹20,000 & reduce your overall taxable gain to ₹30,000. With tax harvesting, you will only pay tax of ₹3,000 instead of ₹5,000.
Reducing your STCG tax liability
Since short-term capital gains are taxed at 15% irrespective of the amount of gain, you cannot avoid paying STCG. However, you can reduce your tax liability by offsetting short-term capital losses against gains.
The offsetting process works the same as described above for long-term capital losses. Investors must remember that long-term capital losses can only be set off against long-term capital gains. However, short-term capital losses can be used to offset both long-term and short-capital gains. Additionally, unused short-term/long-term losses can be carried forward & offset against gains for up to 8 years.
Tax-loss harvesting can be helpful especially for avid stock market investors to maximise their returns and minimise the tax bill. Since it is not a one-time event, it requires continuous and active monitoring of gains and losses. By reinvesting the redeemed amount, investors can continue to compound their returns and lower the impact of taxes on their returns.
Disclaimer: The content in this article is purely the author’s personal opinion and is for informational and educational purposes only. It should not be construed as professional financial advice and nor to be construed as an offer to buy /sell or the solicitation of an offer to buy/sell any security or financial products.
Naveen KR is smallcase manager and Senior Director at Windmill Capital