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Tax loss harvesting: Is it helpful in reducing capital gain taxes?

If you are an active investor or a trader in the stock market, then the term tax loss harvesting would not be new to you. It is an opportunistic way to increase your post-tax returns on the investment. In this article, we shall discuss tax loss harvesting in detail.

Meaning of Tax-loss harvesting

When you invest in something, your main objective is to earn money from your investment. However, one needs to understand that in case some stocks perform well in a well-diversified portfolio, but few of them don’t even provide a break even.

Tax loss harvesting is a sort of a tool that is used by investors by selling off securities with negative returns at a loss in order to offset the capital gain tax liability. It is also called as tax loss selling. Generally, this strategy is implemented near the end of the financial year, however, one can harvest their losses at any point in a particular financial year to reap benefits. Although it may not restore an investor to their previous position, it certainly can reduce the severity of the loss.

For example, a loss in security A’s value can be sold to offset the increase in Security B’s price, thereby eliminating the capital gain tax liability of Security B.

This method is usually used for short term capital gains because they are taxed at higher rates than long term gains, but one can also use this strategy for long term gains.

When an investor sells investment for profit, the gains are long or short term. In case an investment is held for more than a year, then it’s considered as a long term gain and less than a year is considered as short term gain. In case of long term investments, LTCG tax^[1] is attracted at 10% above 1 lakh rupees, whereas in case of short term investments, it’s taxed at 15%.

Tax loss harvesting is a strategy that can be used to turn off a portion of capital losses into tax offsets in order to reduce the outflow of capital gain tax. When you sell some of your investments at loss to offset gains realized on other stocks, then you have to pay tax on net gains only.

Investors can proceed by selling off the flopping investments in return to buy an asset with similar nature to maintain portfolio allocation.

You should keep in mind that in case you desire to harvest losses and offset them against gains, the entire sale transaction has to be completed within the financial year.

Harvesting helps in reducing the tax liability on the capital gains of the particular financial year, and the income tax act permits you to carry forward capital losses for consecutive 8 years. This can help you to harvest the losses of investments who have bleak chances of improvement. For such investments, you may book losses and carry forward them for offsetting against future capital gains. 

How to calculate losses?

In case where you have made a lump-sum purchase of an investment, then calculation of gains and losses would not be an arduous task. The difference between purchase and sales of stocks shall provide you the number of capital gains or losses, but if the investment you seek to harvest was invested through the SIP mode, then its record keeping would be difficult. You may be required to get the details of each purchase date and value in order to compute the holding period and gains/losses separately for every SIP transaction.

Example of Tax loss harvesting

This concept can be best understood through the below-mentioned example:

Imagine Mr C is an investor with the following portfolio:

Portfolio-

• Mutual Fund X- 3,50,000 rupees unrealized gains, held for 380 days.
• Mutual Fund Y- 1,30,000 rupees unrealized loss held for 635 days
• Mutual Fund Z- 1 lakh rupees unrealized loss, held for 138 days

Trading Activity-

• Mutual Fund A- Sold, realized gain of 3 lakh rupees. Fund held for 380 days.
• Mutual Fund B- Sold, realized gain of 1,50,000 rupees. Fund held for 150 days.
• The investor harvested loss by selling mutual funds Y and Z, which helped to offset gains, and the tax liability would be 14,500 rupees.

Therefore by harvesting losses of mutual funds Y and Z, the liability of tax is reduced from 42,500 rupees to 14,500 rupees which means an amount of 28,000 rupees can be saved on capital gain taxes.

Conclusion

Therefore it can be concluded that by using this tax loss harvesting strategy, investors can get significant amount of tax savings. However, it is worth mentioning here that they should be cautious that stocks that have a long term negative impact and less chances of improvement should be harvested.

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