March 31 deadline is getting near. How to save income tax with tax loss harvesting?

March is an important month for taxpayers. It is that time of the year when they leverage government-provided tax exemptions and reduce their tax liability. In other words, it is tax planning, which is a legal approach used to minimize the amount of income tax owed. This must not be confused with tax evasion which involves fraudulently understating income or overstating expenses to avoid tax.

Under the old tax regime, apart from the deductions under various sections like Section 80C of the Income-tax Act, investors usually turn to tax loss harvesting to save some more taxes.

Many of us pay tax on salary, interest, and capital gains amongst other heads. If we talk about taxation on capital gains, it is applicable according to the period for which the securities or investments are held. The following table focuses on capital gains tax that is applicable to equity and debt securities. However, tax rates may be different for gold, real estate and other investment avenues as well.

What is tax loss harvesting?

Tax loss harvesting is the practice of selling a security that has incurred a loss, in order to reduce or offset the capital gains that are subject to taxation.

Let’s understand this with an example related to equity. For ease of understanding, we have assumed that STT and cess are not applicable.

Scenario 1
Let’s say that an individual earned ₹1,00,000 in short-term capital gains (STCG) this year. He will have to pay 15% of this amount, i.e., ₹15,000 as tax. Scenario 2
Let’s assume that in addition to the above, the individual already holds stocks with an unrealized loss of ₹60,000. Now what the investor can do, is to sell these stocks at a loss and offset the capital gains of ₹1,00,000. On net basis, he will now have capital gains of ₹40,000, i.e., ₹1,00,000-₹60,000. As a result, he would be required to pay ₹6,000 as tax (15% of ₹40,000). Therefore, he saved ₹9,000 in taxes (₹15,000-₹6,000).

This process of using losses to offset gains is called tax-loss harvesting.

Now you might wonder that it doesn’t make sense to sell at a loss, just to save taxes. Well, there is no explicit regulation in India that disallows tax loss harvesting. Individuals can buy those same stocks and continue to hold them, immediately after selling them at a loss.

Tax loss harvesting on long-term capital gains

Again, let’s understand this with the help of an example.

Scenario 1
Let’s assume that an individual has a long-term capital gain (LTCG) of ₹5 lakh, that means he sold some stocks after holding it for more than a year. He will be required to pay a 10% tax on ₹4 lakh (₹5 lakh- ₹1 lakh exemption), i.e., ₹40,000.

Scenario 2
Suppose he has a few more stocks with an unrealized loss of ₹3 lakh. In the month of March, he sells these stocks and books losses. This unrealized loss now becomes a realized loss. Moreover, he immediately buys the same stocks which he sold, at the same price.

He is now left with a realized capital gain of ₹2 lakh (₹5 lakh- ₹3 lakh). However, he has to pay a 15% tax only on ₹1 lakh (₹2 lakh-₹1 lakh which is exempt). This tax amounts to ₹10,000, i.e.10% of ₹1 lakh. Therefore, he managed to save ₹30,000 in taxes (₹40,000-₹10,000) with the help of tax loss harvesting.

It needs to be noted that long-term capital losses can be offset only against long-term capital gains. However, short-term capital losses can be offset with both long-term and short-term capital gains.

It is important to remember that stocks are bought and sold according to the FIFO method (first-in-first-out). Basically, the stocks which are bought on an earlier date are sold first. This helps in determining the holding period and capital gains tax is calculated accordingly.

Stocks and mutual funds are both considered as equity when availing the exemption of ₹1,00,000 for LTCG taxation. While doing tax loss harvesting, one must look into the impact of exit load charged by mutual funds.