Offset Your Tax Liabilities Through Tax Loss Harvesting
The Union Budget’s amendment of 2018 announced taxation on long-term capital gains above Rs.1 lakh. This encouraged the investors to follow the policy of tax loss harvesting to minimise the effects of taxation. Tax loss harvesting allows investors to sell loss-making stocks which offset the gains realised from selling other profitable stocks. This way, an investor is liable to pay taxes only on the net profit (the amount they gained minus the amount lost), which reduces the tax bill.
This article discusses the concept of tax harvesting as a means to offset capital gains against capital losses. Keep reading to get the details.
What is Tax Loss Harvesting?
Tax loss harvesting is a tax-saving strategy whereby you can sell your loss-making funds to reduce tax liability on gains. This helps offset the net capital gains against losses and makes the investor eligible for lesser tax deductions.
Experts believe that harvesting tax loss is especially profitable for investors who are in the upper bracket of taxation. The high-income tax bracket implies you can save more by minimising your taxable gains.
How does the Tax Loss Harvesting Work?
The functioning of tax loss harvesting is straightforward. It involves keeping capital gains at a minimum level to keep the tax bill low. It begins with identifying a stock or equity fund experiencing regular price decline.
The next step involves selling that stock or equity if its value has floored beyond a limit with bleak chances of survival. Also known as loss realisation, this step actually helps offset your losses against capital gains earned from your portfolio.
Investors aim to use this strategy towards the end of a financial year, although you can keep capital gains to a lower level throughout the year. The gains from the sale of the loss-making stocks can be further reinvested in a profit-making stock or equity fund. This reinvestment helps balance your portfolio’s asset allocation.
Also Read: Deductions From House Property Income Under Section 24 Of The Income Tax Act
Key Tax-Loss Harvesting Rules
There are certain rules that investors need to follow before they opt for tax loss harvesting. These are as below:
- Tax loss harvesting is not applicable when there are no realised profits or if realised losses are higher than realised profits.
- The First In, First Out method is applicable for calculating buy average and Profit and Loss (P&L) accounts. Thus, investors need to sell their entire stock holding to book short-term capital loss if the short-term loss-making stock has long-term potential.
What are the Benefits of Tax-Loss Harvesting?
Tax loss harvesting is a practice that involves tweaking your portfolio balance in a way so that it records minimum capital gains. There are various benefits of harvesting such losses, which are as below:
1. Lowering tax bills: Investors look for every single opportunity to lower their taxes on capital gains. Reducing the taxable amount is one such way that benefits investors. Some instances where investors use tax loss harvesting to lower tax bills are:
- Investors can offset their losses through tax loss harvesting when the market is not strong enough to gain traction. However, when the market gains momentum over longer periods, the gains from selling assets may be higher than the tax benefits.
- Investors may choose this strategy when they face the demand for liquidity. The demand for sudden liquid money may arise for personal financing projects, to protect against future cash crunches, or for purchasing other stocks and funds.
- Investors may perform this strategy to maintain a balance between financial goals and risk tolerance. Some feel the need to reshuffle their portfolio and minimise their losses and capital gains. Thus, investors may perform this strategy when they have more government or tech stocks than energy or small-cap funds.
2. Wash sale trading: To make way for alternative investments that are profitable, investors may sell their loss-making security and repurchase a ‘substantially similar’ stock within 30 days. The span of a Wash sale is 61 days (30 days before and after selling the asset).
- Experts believe that wash sales can be profitable if an identical stock/security is repurchased. Although the Internal Revenue Service (IRS) restricts US traders from Wash selling, there are no bans on performing it in India. Wash Sale also makes sense if the sold stock is repurchased by an individual who is directly related to the investor.
Tax-Loss Harvesting Tips
The tax harvesting strategy helps investors convert their losses and simultaneously save on tax payments. It is especially crucial during years when the stock market reaches new heights. Some important tips for performing tax loss harvesting are:
- Loss aversion is a method of protecting investors and giving them a chance to revive their portfolios. Many retail portfolios feature loss-making stocks, which are used to offset capital gains.
- Always look for loss aversion through loss harvesting during bear markets. Since your capital gains consist of both long and short-term capital gains, it is important to rebalance your folio to take advantage of market fluctuations. This helps convert your low-quality stocks to high-quality ones that you can hold longer.
- Get rid of position-sizing mistakes, especially during bullish market conditions. You can perform tax loss harvesting when you feel that your portfolio has more equity shares, especially high-risk equities of companies suffering from fluctuations.
- Tax loss harvesting makes way for removing your bullish market buy prices for stocks and funds. The tremendously fluctuating speculative market does not consider your buy prices and instead concentrates on their future prospects.
How Much Can you Save by Tax Loss Harvesting?
To better understand the exact calculation of tax harvesting, take an example of a uniform investment portfolio. Apart from stocks and equity funds, assume that Rahul’s portfolio consists of debt funds and other securities as well.
At the end of the financial year 2022-23, Rahul’s portfolio consists of the following capital gains figures.
Short term capital gains = Rs. 85,000
Long term capital gains = Rs. 1,80,000.
According to the Income Tax Act, the taxation on capital gains is given as:
- Tax on Short term gains = 15% of Rs. 85,000 = Rs. 12,750
- Tax on Long term gains = 10% of (1,80,000 – 1,00,000) = Rs. 8000
- Total tax liability for the financial year 2022-23 = Rs. 12,750 + Rs. 8000 = Rs. 20,750.
However, on careful observation, Rahul realises that a chunk of stocks in his portfolio is underperforming. With minimum chances of survival, Rahul plans to sell these stocks and perform tax-loss harvesting.
After selling these stocks, Rahul declares short-term capital losses amounting to Rs. 50,000. He purchases potentially profitable stocks with the amount received or performs wash sales and buys similar stocks within the wash sale period.
Therefore, his new tax liability accounts to
- Tax on Short term gains = 15% of (80,000 – 50,000) = Rs. 4500
- Tax on Long term gains = Rs. 8000
- Total tax liability = Rs. 4500 + Rs. 8000 = Rs. 12,500
Thus, total tax savings after performing tax loss harvesting = Rs. 20,750 – Rs. 12,500 = Rs. 8250. Additionally, Rahul can also reap benefits from the purchase of new stocks if they perform well. Additionally, this assists in maintaining his portfolio.
When should you use Tax-Loss Harvesting?
There are multiple scenarios when investors might choose to go for tax loss harvesting. Some of them are as follows:
- If you have multiple investments that are subject to capital gains taxes
- If you wish to shift to a lower tax bracket
- If you made some bad investment decisions during a financial year
Also Read: Everything To Know About Section 194Q Of The Income Tax Act
Final Word
Selling off underperforming stocks to obtain tax credit for the loss is an efficient tax saving strategy. Irrespective of the reason why an investor might choose to harvest tax losses, it provides them immediate relief. However, it is advisable to utilise this strategy when the profits on equity holdings and loss-making capacity are aligned as per the investor’s financial goals.
FAQs on Tax Loss Harvesting
Ans: Investors can offset their long-term capital losses against long-term capital gains by selling loss-inducing stocks and profit-making stocks at the same time. Similarly, short-term losses can be offset by short-term gains alone.
Ans: Yes, it is legal if the investors calculate their capital gains and find a way to decrease their tax liabilities by complying with the regulations. Tax loss harvesting is simply reshuffling one’s portfolio by removing stocks that are underperforming with those that perform relatively well.
Ans: Some popular tax loss harvesting strategies include reinvestment of mutual fund distributions, making year-end distributions and identifying the different types of capital gains.
Ans: No, selling your stock holdings and buying similar stocks again on the same day will be considered as an intraday trade. For tax loss harvesting, investors have to engage in a delivery sell transaction.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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