The Minance Guide to Tax Loss Harvesting
A step by step walkthrough on how to do tax loss harvesting in India
Most investors leave their taxes be till the end of the year and when they find that they have a high tax liability, they hunt for ways to reduce it. What they don’t realize is that it is advantageous to plan taxes much in advance. This is were Tax Loss Harvesting comes in.
Tax-loss harvesting (TLH) is the practice of selling stocks, mutual funds, and other securities that have declined in value. By realizing or ‘harvesting’ a loss, investors can reduce taxes on both gains from other investments and from income.
TLH is considered to be a complex technique and thus, not widely used by investors who generally have inadequate or no knowledge of taxes. We thought we could fix this.
How to implement Tax-loss harvesting-
While we have simplified the process greatly, it still involves several steps and so, we will illustrate each step with the help of an example:
Mr. Jhunjhunwala (J) is a long-term investor who buys and holds equity shares for long-term capital appreciation. Mr. J has a portfolio of many stocks, out of which some have reduced in value while some have increased in value.
Step 1: Define the financial year for which you intend to harvest losses
Tax liability is calculated for the income earned in a particular financial year. So, it is important to note the year before you start.
The relevant financial year for Mr. J is 2017–18 (1st April, 2017–31st March, 2018)
Step 2: Determine and estimate your incomes for the year
As mentioned earlier, it is more beneficial to check for harvesting opportunities round the year and not leave it for year-end. However, as you will only know your actual income after the financial year ends, it is best to check for income as on current date and then estimate your income for the rest of the year.
Apart from investing, Mr. J is working in an IT company and owns 2 flats, one of which is rented out.
Step 3: Based on the nature of income, classify the incomes into different heads-
This could be — Salary income, Rental income, Business/Professional income, Long-term capital gains (LTCG), Short-term capital gains (STCG), and Miscellaneous income.
There is not much to be explained about salary and rental income but there is ambiguity about the nature of income from sale of securities. These incomes are to be grouped on premises of tax laws and the simplified summary to find nature of gains resulting from sale of shares is as follows:
If a security is held as investment, the gains arising on sale of investment will be classified as Capital Gains.
Depending on the holding period of security (1 year in case of listed equity shares) the gains will be further classified into LTCG and STCG.
However, when securities are held as stock-in-trade the gains are taxed as Business Income. Business income should be broken into Non-speculative income and Speculative income*:
- Active trading in equity — the income arising shall be taxed as Non- speculative business income.
- F&O trading- the income shall be taxed as Non-speculative business income.
- Intraday trading– the resultant income shall be termed as Speculative income.
*This is important to understand since as per Indian tax laws, one cannot set-off the losses of speculative business with profits of non-speculative business.
Mr. J’s salary income is Rs. 15 lakhs per annum. His rental income (after available deductions) is Rs. 5 lakhs per annum. Since he is an investor, his nature of income from sale of equity shares will be either long-term or short-term capital gains, depending on the holding period.
Step 4: Evaluate your portfolio periodically and keep track of when the stocks in the portfolio are about to cross the 1 year* holding period
As per the Indian tax laws, the short-term capital gains for sale of listed equity shares are taxed at 15% whereas the long-term capital gains are exempt. (From FY 18–19 onwards, LTCG of more than 1 lakh will be taxed at 10% without indexation).
Further, the law allows us to carry forward our losses for set off against gains for 8 years.
Mr. J’s Portfolio decides to evaluate his portfolio on 10th February, 2018-
He is aware that the stock C & D that he is still holding are in losses. His tax liability on the gains would be Rs. 15,000 (15% of STCG, LTCG is exempt).
Step 5: Note the period for which you intended to hold this investment and the portfolio
Mr. J intends to hold on to his stocks C and D for 2 more years.
Step 6: Analyze the effect of selling declined investments on the portfolio
If Mr. J sells Stock C on 10th February, he can book short-term capital losses of Rs. 30,000, thus, reducing his tax liability by Rs. 4,500 (15% * 30,000).
However, selling Stock D will not give him any benefit since the LTCG of Rs. 60,000 is exempt and as set off of LTCL with STCG is not allowed.
He decides not to sell stock C immediately thinking the market might correct further. He waits and evaluates his portfolio continuously. On 10th March, 2018, he sees that stock C has further corrected increasing the notional loss to 40,000.
He is still bullish on the stock for his longer-term horizon of 2 years and is confident that the stock will get him good returns. He knows his taxes well and understands that if he books his losses now and buys the same stock again, he will be able to book short-term capital loss which can be set off against his other gains.
Even if Mr. J did not have any other gains, this loss can be carried forward for 8 years for set off with any short-term or long-term capital gains in future. However, implementing this strategy is not as easy as it sounds. There is a small risk involved which the investor will have to take.
A note on the settlement model
The Indian stock market operates on a T+2 settlement model. Further, for arriving at the settlement day; all intervening holidays, which include bank holidays, exchange holidays, Saturdays and Sundays, are excluded.
Typically, trades taking place on Monday are settled on Wednesday, Tuesday’s trades are settled on Thursday and so on.
So, if Mr. J sold his shares on 10th March, 2018 and bought them again either on the same day, or on 11th March or 12th March, 2018, the old shares which were sold by him would not have been settled from his account and this would change the nature of his transaction from investment to speculative trading.
To give effect to his strategy, Mr. J will need to buy new shares of company C only after T+2 days thereby not changing his desired portfolio. This exposes him to the risk of the stock moving higher in those two days.
To counter the upward movement risk, Mr. J can research and buy another stock which has a correlation of 1 with the stock C. This will most likely protect him from any sector / industry specific movements.
Step 7: Possibility of harvesting losses after considering tax provisions
As per Indian Income Tax Act, 1961 — listed equity shares/units of equity oriented funds which are held for more than 12 months are classified as Long Term. If held for 12 months or less, they are classified as short-term.
In case of units of debt oriented fund a period of 36 months shall be substituted for 12 months.
Stock C being a listed equity share is a short-term capital asset as it’s held for less than 12 months (i.e., from 11/08/17 to 09/03/18).
Long-term capital loss can be set off only against Long-term capital gain. However Short-term capital loss can be set off against Long-term capital gain or Short-term capital gain. Carry forward of capital Loss is allowed for eight years succeeding the year of occurrence.
However, up to financial year 2017–18 as Long-term capital gains arising from sale of listed equity shares or units on which STT is paid was exempt from tax, any losses arising from the same would be ignored.
The loss of Rs. 40,000 from stock C being a STCL can been offset against STCG of Rs. 1,00,000 from stock A. Therefore, the gains would come down to Rs. 60,000 and result in tax savings of Rs. 6,000.
Step 8: Evaluate financial viability of this strategy for your case
Tax-loss harvesting only defers taxes and the real savings come due time value of money. The taxes saved in a year can be invested to earn returns. The longer the term of investment, higher will be the earnings due to compounding effect.
Mr. J should look for investment options for investing the tax savings and rates of return from these options.
The tax savings of Rs. 6,000 mentioned above is based on the assumption that tax rates will remain same in the future too. But the actuality is that every year various tax amendments are introduced in the Finance Bill and thus, it might so happen that the tax rate is increased or lowered.
In case the future tax rates are lowered or the tax payer falls in a lower slab in the future, in addition to the earnings from investment of taxes deferred he will also earn due to the lowered future tax rate. On the other hand, where the tax rates are increased the practice of loss harvesting might have a negative effect.
He also needs to check the possibility of changes in future tax rates before deciding.
Step 9: Implementation
After understanding the various risks involved, Mr. J decides to go ahead and book his losses of 40,000, resulting in a tax saving of 6,000 (15% * 40,000). He buys the stock C after a 3-day gap at a slightly higher price which resulted in him paying 2,000 extra.
But Mr. J was happy since his strategy to harvest his tax losses worked out well and his net savings was Rs. 4,000 (6,000–2,000).
He invests Rs. 4,000 in mutual funds to earn an approximate return of 20–25%.
Note: For more details please refer our white paper on ‘Tax Loss Harvesting’.
Minance is a wealth management firm based in Bangalore. To know more, visit our website.
