Tax Loss Harvesting for Stock Traders
Stock traders are investors in Financial markets who purchase and sell securities like equity shares to earn profits. Before 2018, there was no Long Term Capital Gains tax (LTCG) on the sale of listed equity shares that were liable for STT. However, the amendment made through Finance Act 2018 brought the LTCG on such sales under income-tax purview. This required the stock traders to think about more tax planning and strategies to reduce their tax liability.
Tax loss harvesting is one of those strategies that can increase the post-tax return if applied in a planned manner.
Let us understand in detail about Tax loss Harvesting and how it is beneficial for Stock traders.
How does Tax Loss Harvesting Work?
Whenever a stock trader makes an investment in equity shares and earns a profit or loss, such profit or loss can be considered either a Capital Gain or Profits and Gains from Business or Profession (PGBP). The Central Board of Direct Taxes (CBDT) laid out 3 broad rules for ratifying this classification.
- If the trader classifies the investment as stock in trade, in such case then the income shall be treated as business income.
- In case of a long-term capital gain from the sale of a listed equity share, the trader is entitled to opt to treat the same as capital gains. However, he should maintain consistency in this classification and once opted will not be changed in future years.
- The classification between PGBP and Capital Gains can be done based on Significant trading activity.
If the trader opts for option 2 above, wherein the profits or losses will be classified as Capital Gains or Losses, he is liable to pay Capital Gain tax as per the provisions of the Income-tax Act, of 1961.
In such cases, for tax planning, the trader uses the strategy of taking the advantage of a drop in value to reduce the tax liability. The strategy works like this –
When any equity shares are sold by the trader which results in a Capital Gain, on the other hand, he also sells the equity share of the company which is contributing to a loss in a portfolio. So that such loss can be set off against capital gains earned, thereby resulting in Nil or less tax liability.
There can be a case where the trader is not willing to sell the loss-making share as he anticipates that the share will become profitable in the long term. So, to ensure that such shares form part of a portfolio for a longer term, the moment he sells the loss-making stock, he can immediately place a different order by again purchasing the company’s shares. This keeps his portfolio intact and his resulting capital gain is reduced to a larger extent.
Things to Keep in Mind while Tax Loss Harvesting
While practicing this tax loss harvesting strategy, one also must keep in mind the Income-tax provisions that specify the tax treatment and manner of set-off. 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 share listed on a recognized stock exchange is sold by the investor after 12 months, it would be considered a long-term capital gain.
- In the case of LTCG, the assessee (in this case stock trader) is eligible to claim the tax exemption of Rs 1,00,000 on its gains and pay tax on the balance amount.
Let us understand this with some examples :
Example 1 – Mr A is a stock trader and has a portfolio that made a Short-Term Capital Gain (liable to tax u/s 111A) of Rs 1,00,000 and a Long term Capital Gain of Rs, 1,05,000 (liable to tax u/s 112A). 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 stock from his portfolio which is incurring a loss. So in the same financial year, he sells his loss-making equity share 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)
Example 2 – Mr A had a portfolio that made a short-term capital gain of Rs 2,00,000, and a long-term capital loss of Rs, 1,05,000.
Tax Payable = (Rs 2,00,000 * 15%) = Rs 30,000.
In this case, Mr A has a Long Term Capital Loss of Rs 1,05,00 but he can’t set this off against Short Term Capital Gain. However, in this case, the loss can be carried forward up to 8 assessment years and Mr A can use this loss for reducing tax liability on long-term capital gains that he may earn in the future)
So now, to reduce the tax liability on short-term capital gains of Rs 2,00,000, Mr A can then plan to sell loss-making shares from his portfolio which is held for a period of not more than 12 months and incurs a short-term capital loss of Rs 1,50,000. So here, the tax liability would be as below:
Tax Payable = [(Rs 2,00,000 – Rs 1,50,000) * 15%] = Rs 7,500.
By using the Tax Loss harvesting strategy here he saved tax amounting to Rs. 22,500. (30,000-7,500)
Note: The amount realized from the sale of loss-making shares/stock can also be used to buy a lucrative stock. By this, a trader can maintain the original asset allocation in the portfolio. It also helps in keeping the portfolio’s risk-return profile intact.
Benefits of Tax Loss Harvesting :
- Offsets Capital Gains against losses and reduces overall tax liability.
- If the losses are larger than the gains, a loss can be carried forward for up to 8 assessment years. 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 stocks 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 stock trader/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 stocks in his portfolio which can then be used to incur capital loss and reduce the tax payable on capital gains.
Frequently Asked Questions
Can I sell and buy the stock on the same day?
Yes, you can sell and buy the same or similar stock from the same industry or in any lucrative stock on the same day.
Is tax loss harvesting steps expensive to implement?
Ideally, this is done to increase your post-tax return. Still, a trader must consider the costs involved in it like stamp duty, brokerage, STT, etc. if these are not considered carefully this may nullify all benefits.
Can I use this strategy with other investment classes like Mutual Funds, Bonds, and Options?
Yes, it can be done for other investment classes as well in a similar manner as it is done for equity shares.
Whether tax loss harvesting strategy can be used for both Long term as well as Short Term Capital Gains?
Yes, it can be used for both LTCG as well as STCG.
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.