Tax Loss Harvesting for Mutual Funds
A mutual fund (MF) is a pool of money managed by a professional fund manager. It collects money from several investors and intends to invest its money into various securities like equity shares, bonds, money market instruments, etc. Before 2018, there was no Long-Term Capital Gain tax (LTCG) on the sale of mutual funds, however, the amendment made in Union Budget 2018 brought the LTCG on the sale of securities including MFs under tax purview. This is one of the reasons why MF investors started formulating strategies to reduce their tax liability.
Tax loss harvesting is one of those strategies which can lead to an increase in the post-tax return if applied in a planned manner.
Let us understand in detail about Tax Loss Harvesting for mutual funds :
Things to Keep in Mind before implementing Tax Loss Harvesting strategy
While practicing the tax loss harvesting strategy, one must keep in mind the Income-tax provisions that specify the tax treatment and manner of setoff. Some of the important provisions are as below :
- Long-term capital losses can be set off only against long-term capital gains.
- Short-term capital losses can be set off against short-term as well as long-term capital gains.
- If the equity-oriented MFs are sold by the investor after 12 months, it would be considered a long-term capital gain.
- In the case of LTCG on equity-oriented MF, the assessee (in this case MF investor) is eligible to claim the tax exemption of Rs 1,00,000 on its gains and pay tax on the balance amount. For other MFs this exemption is not applicable.
How does Tax Loss Harvesting Work?
Tax Loss Harvesting works in various ways as below:
A. Set off route
It requires the investor to incur Capital Losses and set off against Capital Gains.
1. Investment is made in mutual fund units; there is either a capital gain or a loss at the time of sale of such units.
2. If an investor earns capital gains on the sale of mutual fund units, he is liable to pay Capital Gain tax as per the provisions of the Income-tax Act, 1961.
3. For tax planning, in such cases the investor identifies which investment in his portfolio has a drop in value of the investment.
4. He sells such investments in the mutual fund units which are contributing to a loss in a portfolio.
5. Such loss is then used to set off against capital gains earned, thereby resulting in Nil or less tax liability.
There can be a case where the person is not willing to sell the loss-making MF investment as he anticipates that the investment will become profitable in the long term. So, to ensure that such mutual fund units form part of a portfolio for a longer term, the moment he sells the loss-making mutual fund, he can immediately place a different order by again purchasing the same mutual fund. This keeps his portfolio intact and his resulting capital gain is reduced to a larger extent.
Let’s understand this with an example
- Mr A is the investor and has a portfolio that made a Short-Term Capital Gain of Rs 1,00,000 (u/s 111A of Income-tax Act, 1961) and a Long term Capital Gain of Rs 1,05,000 (u/s 112A of Income-tax Act, 1961) from the sale of mutual fund units. The Tax liability will be as below:
Tax Payable = (Rs 1,00,000 * 15% STCG tax) + [(Rs 1,05,000- Rs 1,00,000)*10%] = 15,500
- To reduce the tax liability, Mr A plans to sell mutual fund units from his portfolio which is incurring a loss. So, in the same financial year, he sells his loss-making investment and incurs a short-term capital loss of Rs 50,000. So, in this case, the tax liability will be as below :
Tax Payable = [(Rs 1,00,000 – Rs 50,000) * 15% STCG tax] + [(Rs 1,05,000- Rs 1,00,000)*10%] = Rs 8,000
- So, by using the Tax Loss harvesting strategy he saved tax amounting to Rs. 7,500. (15,500-8,000)
B. Re-investment Route
It requires the investor to withdraw the Long term Capital Gains before it exceeds the exemption limit of Rs 1 lakh in a financial year.
1) Investment is done in mutual fund units and these units are held beyond 12 months
2) After crossing 12 months the investment value has appreciated but the appreciation amount is yet to cross Rs. 1 lakh.
3) Investor sells his investment and realizes the long-term capital gain.
4) Since the amount of gain is less than Rs 1 lakh there is no Capital Gain tax as per the provisions of the Income-tax Act, 1961.
5) As the investor was not willing to sell his investment but sold it just to save the tax liability, after such a sale he can re-invest all the sale proceeds again to buy the same mutual funds.
6) Now this re-investment will be treated as a new investment, and its cost of purchase will be the re-investment value.
7) By this he ensured that his portfolio was intact without incurring any tax on Long term Capital gains.
Let’s understand this with an example:
- Mr A invested Rs 4,00,000 in the equity mutual fund on 10th October 2020. On 10th November 2021, the value of the investment became Rs 4,98,000.
He sells this investment (pays STT thereon), and earns a long-term capital gain of Rs 98,000 (Rs 4,98,000-Rs 4,00,000). The Income-tax Act, of 1961 exempts long-term capital gains to the extent of Rs 1 lakh. Therefore, the tax liability of Mr A for FY 21-22 is Nil.
- Now, he re-invests the sale proceeds of Rs 4,98,000 on 11th November 2021. So, the cost of investment will be equal to Rs 4,98,000. As of 21st December 2022, the investment value appreciates and becomes Rs 5,50,000.
- He redeems his investment and earns a long-term capital gain of Rs 52,000. (5,50,000-4,98,000). As this long-term capital gain for FY 22-23 is still below 1 lakh the tax liability of Mr A is Nil.
If he had not taken this re-investment route, on the sale of such investment directly on 21st December 2022 his tax liability would have been as below :
Sale proceeds = Rs 5,50,000
Cost of Acquisition = Rs 4,00,000
Long-term capital gains = Rs 1,50,000 (5,50,000 – 4,00,000)
Tax Payable = (1,50,000-1,00,000) *10% = Rs 5,000.
- Benefits of Tax Loss Harvesting :
- Offsets Capital Gains against losses and reduces overall tax liability.
- Loss can be carried forward up to 8 assessment years if the losses are larger than gains. So, the loss incurred in one Financial year can be used to save tax on gains earned in the next financial year.
- If one ends up having an unbalanced portfolio, it allows him to re-align the investment by reinvesting the money with the preferred allocation that meets the investment needs without having to incur any additional tax liability.
- It helps to increase the post-tax returns.
- Limitations of Tax Loss Harvesting :
- Without having a clear understanding of the Provisions of Income Tax Act, 1961 on Capital gains one cannot perform this.
- Not all investments perform the way they are intended to perform, in some cases the loss-making investment which was sold to set off the tax liability may turn highly profitable if the investor would have held it for a long term. So sometimes selling the loss-making investments can result in Opportunity loss.
Tax loss harvesting is beneficial if one has earned capital gains and has underperforming investments in his portfolio which can then be used to incur capital loss and reduce the tax payable on capital gains. Also, it helps to save tax for investment value which is on an appreciation trend and has gained less than Rs 1 lakh in a particular Financial year.
Frequently Asked Questions
Can I sell and buy the same mutual fund on the same day?
Yes, you can sell and buy the same or similar units of mutual funds on the same day.
Is tax loss harvesting steps expensive to implement?
Ideally, this is done to increase your post-tax return, but an investor must consider the costs involved in it like stamp duty, brokerage, STT,exit load on mutual funds etc. if these are not considered carefully this may nullify all benefits.
Can I use this strategy with any other investment classes also?
Yes, it can be done for other investment classes as well (like equity shares, bonds, options, etc.) in a similar manner as it is done for mutual funds regarding the taxability under the relevant provisions of the Income-tax Act, 1961.
Can tax loss harvesting strategy be used for both long-term and Short Term Capital Gains?
Yes, it can be used for both LTCG as well as STCG.It is more beneficial in case of LTCG as you can save tax on 1 lacs rupees every year.
Is Tax Loss Harvesting Legal?
Tax Loss Harvesting is acceptable in India as there are no legal regulations as such that prohibit the use of this strategy.