Long Term Capital Gains From Mutual Funds: Types And Taxation

Mr. Singh invested in various equity and debt funds four years ago. Recently, he has sold all of them and had to pay certain taxes for them.

So, what taxes did he have to pay for gains from his investments?

Depending on the holding period of investment and the type of mutual fund (equity or non-equity), he will have to pay a certain tax for capital gains earned from his investments.

For equity-oriented funds, an investment period of over 12 months results in long-term capital gains on mutual funds. In the case of non-equity mutual funds, the holding period is 36 months for LTCG to be applicable. 

Now let us take a look at long-term capital gains and taxes applicable on it. 

What Is a Capital Gain/Loss?

Capital gain or loss happens when an investor sells capital assets at prices below or above the original purchase price. Investment products such as houses, lands, buildings, jewellery, stocks or mutual fund units, etc., are such capital assets.

Capital gains tax is not applicable on inherited properties as there is just a change of ownership and no sales. It is also not applicable for the following assets:

• Raw materials or consumables used for any profession or business
• Agricultural land
• Goods meant for personal use, for example, furniture, clothes, etc. 
• Special bearer bonds issued in 1991
• Deposits on gold bonds through various schemes

Capital gains materialise when there is an increase in the value of capital assets, and you realise the said gains by selling them. In other words, capital gains occur when the selling price of an asset is higher than its purchase price. Whereas when you sell capital assets at a price lower than the purchase price, it results in a capital loss. 

Capital gains are taxable income according to the Income Tax Act, 1961. To get tax benefits on capital gains for a financial year, the change of ownership of the capital asset must happen in the previous fiscal year. 

Also Read: Commodity Mutual Funds In India

Types of Capital Gains on Mutual Funds

Capital gains on mutual funds happen when the fund manager sells or transfers securities at the opportune moment for capital appreciation. Depending on the holding period, there are two types of capital gains for mutual funds:

1. Short-term capital gains (STCG): For equity funds and equity-oriented funds, a holding period of less than a year (12 months) results in STCG. For debt funds and debt-oriented funds, the holding period must be less than 3 years (36 months) 
2. Long-term capital gains (LTCG): For listed equity shares, equity funds, and zero-coupon bonds, capital gains earned after 1 year from the date of purchase are subject to LTCG tax. If the holding period is above 3 years for debt funds and other capital assets, the gains are subject to LTCG tax.

Calculation of STCG and LTCG

When calculating STCG for taxation purposes, the capital gains are simply added to the total income. The formula for calculation of short-term capital gains for mutual funds is as follows:

STCG = Full value consideration – (cost of improvement + cost of transfer + acquisition costs)

Calculation of LTCG is slightly trickier as you need to consider the effects of inflation over long periods. The formula for calculating long-term capital gains on mutual funds is as follows:

 LTCG = FVC received or accruing – (indexed cost of improvement + indexed cost of improvement + transfer costs)

Now, let us understand the meaning of these values:

• Full value consideration- Total amount that seller of capital assets has or will receive.
• Cost of improvement: Seller’s expenditure on making alterations or additions to the capital assets.
• Acquisition costs: The value of a specific asset at the time of purchasing it. 
• Indexed cost of acquisition: This is the acquisition cost ascertained by utilising the Cost Inflation Index (CII) to take into account the effects of inflation. The indexed cost of acquisition = Cost of acquisition x CII of the year of transfer / CII of the year of acquisition.
• Indexed cost of improvement: Indexed Cost of improvement = Cost of improvement x CII of the FY of transfer / CII of the year of improvement.

Also Read: Aggressive Hybrid Mutual Funds In India

Taxes on Short-term and Long-term Capital Gains on Mutual Funds

The following lists the taxes applicable on mutual funds:

• Tax on dividend income 

Since Budget 2020, dividends are added to the investor’s income and taxed as per their applicable income tax slabs. Before this, companies issuing dividends had to pay DDT (dividend distribution tax) along with surcharge and cess. 

• Tax on STCG

Profit made from selling units of equity or equity-oriented funds is subject to STCG for holding periods of 12 months or less. For non-equity funds, a holding period of 36 months or less results in STCG taxes. 

STCG on equity schemes is charged at a flat 15% rate under Section 111A. Meanwhile, non-equity funds are treated as regular income and added to the income tax slab. 

• Tax on LTCG

Long term capital gains from mutual funds are applicable for holding periods of over 12 months for equity funds and more than 36 months for non-equity funds. 

For equity and equity-oriented schemes, LTCG is taxed at a flat 10% rate without indexation benefit after a Rs. 1,00,000 tax exemption under Section 112A. LTCG on other mutual funds are taxable at a flat 20% rate after the benefit of indexation under Section 112. 

Final Word

Long term capital gains from mutual funds are taxed at a 10% rate for equity funds and a 20% rate with indexation benefit for other mutual funds. LTCG depends on the holding period, which is different for various assets. For listed equity shares, zero-coupon bonds, units of equity or equity-oriented funds, UTI and other listed securities, a holding period of over 12 months results in LTCG.

For unlisted securities and immovable properties such as land, building or house property, a holding period of more than 24 months is subject to LTCG. In the case of debt funds and other capital assets, it must be over 36 months.

Frequently Asked Questions

1. What are the taxation rules for hybrid mutual funds?

Hybrid funds with equity exposure of 65% or above are treated as equity funds, and their capital gains are taxed as per equity fund rules. Hybrid funds with less than 65% investment in equities have the same taxation rules as non-equity funds.

 2. How are capital gains from SIP investments taxed?

In the case of a Systematic Investment Plan (SIP), each instalment counts as a separate investment for capital gains purposes. STCG or LTCG is calculated on the holding period starting from the date of each instalment to the date of redemption. 

 3. What is indexation for calculating capital gains?

Indexation refers to the practice of recalculating the purchase price of assets to adjust them for inflation. The Cost Inflation Index published by the Income Tax authorities every year helps to calculate indexation.  

Indexation is a great benefit for taxpayers as it allows them to correct the cost of acquisition over many years and reduce their taxable income. 

 4. What are realised and unrealised capital gains?

Realised capital gain occurs when the price of assets appreciates and you sell said assets for profits. On the other hand, capital gains from an investment that you have not sold yet are unrealised capital gains.

5. Can you set off capital losses against capital gains?

Yes, but you can set off capital losses against only a similar capital gain and not against any other income sources. You can set off a long term capital gain against only another LTCG. In comparison, you can offset STCG against an STCG or an LTCG. 

As per Income Tax rules, you can carry forward losses for up to 8 assessment years from the one in which your loss occurred. 

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Disclaimer- Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.