Crude oil prices are skyrocketing due to the Iran war and the resulting closure of the Strait of Hormuz. Brent crude oil prices have crossed the $100 per barrel mark, and India imports most of its oil requirements. This has put pressure on the Indian rupee, bond yields, current accounts and stock markets.
The Nifty 50 index is down more than 15% from its September 2024 peak. Nifty Midcap 150 and Nifty Smallcap 250 indices have fallen even more. If you started investing in the last 1-2 years, your equity portfolio might have seen losses due to the current correction. You can book these losses and reinvest, and in the process save capital gains tax with tax deductions. In this article, we will understand what tax harvesting is and how it can help you save capital gains tax.
What is tax harvesting?
Tax harvesting is a strategy used to reduce capital gains tax or void it. This can be done by booking long term capital gains (LTCG) up to Rs. ₹1.25 lakh on direct equity and equity mutual funds. LTCG up to Rs. Rs 1.25 lakh in a financial year is exempt from tax.
Another way of harvesting tax is to book capital losses on direct equities and equity mutual funds and use them to offset an equal amount of capital gains from other investments. As a result the total capital gains either get reduced or become zero. Little or no capital gains are subject to little or no capital gains tax.
Let us understand this with an example. Suppose Priya invests Rs. Have booked. 2 lakh long term capital gains (LTCG) during the first half of the financial year by redeeming a portion of your equity mutual fund investments. Due to the ongoing stock market correction, Priya’s remaining equity mutual portfolio has incurred short term capital losses (STCL) of Rs. 1 lakh.
Priya can do tax harvesting by redeeming the remaining equity mutual fund portfolio and booking STCL of Rs. 1 lakh. Next day, Priya can buy back the same equity mutual fund. Priya’s purchase price will be reset to the current NAV at which she buys back the mutual fund units.
Let us see how Priya’s capital gains will be taxed.
Long term capital gains = Rs. 2 lakhs
Long term capital gains exemption from taxation during a financial year = Rs. 1.25 lakh
Taxable long term capital gains = Rs. 75,000 (Rs. 2 lakh – Rs. 1.25 lakh)
Short term capital loss = Rs. 1 lakh
Priya can use a part of Rs. 1 lakh STCL to offset taxable Rs. 75,000 LTCG
Taxable LTCG = Nil (Rs. 75,000 STCL is used to offset Rs. 75,000 LTCG)
Remaining Rs. STCL of Rs 25,000 can be carried forward for the next 8 assessment years to offset any future capital gains.
Thus, with the tax deduction, Priya reduced her taxable capital gains to zero, resulting in no capital gains tax. Without tax harvesting, Priya would have to pay LTCG tax of Rs. 9,375 (12.5% on Rs 75,000). So, Priya saved Rs. Rs 9,375 in taxes with tax accrual.
Capital gains taxation rules
To make best use of tax harvesting, you need to understand the rules of capital gains taxation for equity mutual funds and equity shares as follows:
- Short-term capital gains (STCG) are taxed at 20%. Long Term Capital Gains (LTCG) up to Rs. Rs 1.25 lakh are exempted from taxation in each financial year. The incremental LTCG is taxed at 12.5%.
- Short term capital loss (STCL) can be used to offset short term capital gains (STCG) and long term capital gains (LTCG). Long term capital loss (LTCL) can only be used to offset long term capital gains (LTCG).
- Unutilized capital loss in any financial year can be carried forward for up to 8 assessment years to offset future capital gains. Capital losses can be carried forward only if the Income Tax Return (ITR) is filed on or before the due date of filing the tax return.
How to make the most of tax deduction?
Let us look at different scenarios to understand how one can make the most of tax accrual.
capital gains only
Consider a scenario where you get only long term capital gains (LTCG) and no capital loss. You can book LTCG up to Rs. Rs 1.25 lakh is exempt from tax in a financial year. Maximum LTCG tax will be saved. 15,625 (12.5% of Rs 1,25,000). This strategy will work in a rising market or a bull market.
If you are a long-term investor, you have to reinvest the redemption proceeds the next day. The acquisition cost will be reset, and the holding period will start afresh.
Capital Gains and Capital Losses
Consider a scenario in which you have capital gains on some investments and capital losses on others. Capital loss can be booked to offset capital gains booked. You can use capital losses to offset any LTCG only after the first Rs. 1.25 lakh, because there is a discount on it. Any excess capital losses can be carried forward.
On reinvesting the redemption proceeds, the acquisition cost will be reset, and the holding period will start afresh. This strategy is suitable for volatile markets.
capital loss only
Suppose you have started investing in the last 1-2 years. Your portfolio will suffer losses due to the ongoing war in Iran. You can book capital losses and reinvest the next day. Capital losses can be carried forward to offset capital gains in future years. This strategy is suitable for falling markets.
Should you do tax harvesting?
Tax collection is optional. While this helps save capital gains tax, long-term investors should reinvest the redemption proceeds the next day. Failure to do so will result in disruption of long-term compounding and missed financial goals. Tax harvesting works on the basis of financial year. So, if you are planning to do so for this financial year, you must complete the redemption and reinvestment process on or before March 31, 2026. The process can be repeated every financial year.
The tax collection process requires time and effort. In such a scenario, if the capital gains tax amount being saved is small, some investors skip it as they do not consider it worth the time and effort put into it. Use tax harvesting to your advantage for short-term capital gains tax benefits, but not at the expense of your long-term financial goals.