Tax Harvesting: How to Save Capital Gain Tax

Taxes are never fun, but we have to pay them on our earnings, purchases, and even on the profits we make from investing in Mutual Funds from 2018.

In this blog, we will show you how to lower or even eliminate capital gains tax from mutual funds.

What is Tax Harvesting?

Tax harvesting means strategically selling investments to minimise taxes. It is a strategic approach where investors sell underperforming securities to capture losses, a process often referred to as “harvesting” losses. This technique allows investors to efficiently counterbalance taxes owed on gains or income. To execute tax harvesting effectively, investors need to ensure that the securities are removed from their Demat account through a sale or delivery transaction and then repurchased the following day.

Long-term capital gains on equities introduced in 2018 are taxed at 10% if they exceed Rs. 1 lakh annually. These gains come from selling equity investments held for over 12 months. For new investors, gains may not reach the threshold immediately, but with time, they could. For instance, investing Rs. 5,000 monthly in equity funds with 12% returns leads to taxable gains in 5 years, or just 3 years with Rs. 15,000 monthly investment.

Here’s the table displaying the SIP amount and the corresponding capital gains at 12% annualised returns over different periods:

SIP Amount	After 24 months	After 36 months	After 48 months	After 60 months
5,000	15,325	35,396	65,076	1,05,518
8,000	24,520	56,634	1,04,122	1,68,829
12,000	36,780	84,951	1,56,183	2,53,243
15,000	45,975	1,06,189	1,95,229	3,16,554
30,000	91,949	2,12,378	3,90,458	6,33,108

Let’s understand with another example

Initial Investment: You initially invest Rs. 5,00,000 in an asset.

Redemption and Reinvestment: After some time, you redeem this investment and reinvest the entire redeemed amount of Rs. 5,90,000. This resets your investment cost to Rs. 5,90,000, along with the date of investment.

Subsequent Value Increase: Over the next year, the value of your investment increases to Rs. 6,50,000.

Tax Implications Comparison

If you had not redeemed and reinvested, your long-term gains would have been Rs. 1,50,000 (Rs. 6,50,000 – Rs. 5,00,000).

Since the gain exceeds the limit of Rs. 1 lakh, you would have needed to pay a 10% tax on the amount exceeding this limit, which is Rs. 50,000. So, the tax would amount to Rs. 5,000 (10% of Rs. 50,000).

Actual Scenario: However, because you redeemed and reinvested the amount, your gains upon redemption are only Rs. 60,000, which is less than the Rs. 1 lakh limit.

Conclusion: By redeeming and reinvesting, you avoid crossing the Rs. 1 lakh limit for long-term capital gains tax. In this case, you only pay tax on the gains made after redemption, which is Rs. 60,000, and since it falls within the exemption limit, you don’t owe any additional tax.

This shows, the strategy of redeeming and reinvesting helped you optimise your tax liability by staying within the exemption limit for long-term capital gains tax.

Ways to reduce overall taxable income

Investors have three options to consider:

1. Identify investments with capital Losses

Review Portfolio Performance: Regularly assess the performance of all investments within the portfolio to pinpoint assets that have depreciated in value since their acquisition.

Evaluation of Decreased Value: Scrutinise each asset’s current market value compared to its purchase price or initial valuation. Identify the extent of the capital losses incurred.

2. Sell Underperforming Investments

Decision Making: Once underperforming investments are recognized, investors should contemplate whether to divest from these assets.

Consider Long-term Strategy: Assess the broader investment strategy and objectives before deciding to sell. Evaluate if the underperforming assets are likely to rebound in the future or if reallocating capital elsewhere aligns better with long-term goals.

3. Offset Capital Gains

Utilising Losses: Capitalise on the capital losses generated from selling underperforming assets to mitigate tax liabilities resulting from capital gains.

Matching Losses with Gains: Align the nature of losses (long-term or short-term) with corresponding gains. Long-term losses can offset long-term gains, while short-term losses can offset both short-term and long-term gains.

Carry Forward Option: If the magnitude of losses surpasses gains, leverage the option to carry forward remaining losses to subsequent tax years. This facilitates the potential offsetting of future capital gains, thereby optimising tax efficiency over time.

FAQs

1. When is the best time to implement tax harvesting?

Tax harvesting is best implemented towards the end of the tax year or during periods of market volatility to strategically sell underperforming investments and offset capital gains with capital losses, optimising tax liability.

2. Are there risks associated with tax harvesting?

Yes, there are risks like paying fees, difficulties in timing the market, and accidentally breaking rules that prevent buying back the same asset shortly after selling it for tax purposes.

3. Can tax harvesting be done in tax-advantaged accounts?

Tax harvesting minimises tax liabilities by selling investments at a loss to offset gains, but it’s incompatible with tax-advantaged accounts like IRAs or 401(k)s, where it’s redundant and potentially detrimental, compromising long-term tax benefits.