The Iran war and the resultant closure of the Strait of Hormuz have led to crude oil prices skyrocketing. The Brent Crude Oil prices have crossed the $100/barrel mark, and India imports most of its oil requirements. It has led to pressure on the Indian Rupee, bond yields, current account, and stock markets.
The Nifty 50 Index has corrected more than 15% from its September 2024 peak. The Nifty Midcap 150 and Nifty Smallcap 250 indices have corrected even more. If you have started investing in the last 1-2 years, your equity portfolio must 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 harvesting. 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 the capital gains tax or make it nil. It can be done by booking long-term capital gains (LTCG) of up to Rs. 1.25 lakh on direct equity and equity mutual funds. LTCG of up to Rs. 1.25 lakh in a financial year is exempt from taxation.
The other way of tax harvesting is to book capital losses on direct equity and equity mutual funds and use them to offset an equivalent amount of capital gains from other investments. It results in the overall capital gains either being reduced or becoming nil. A lower or nil capital gain results in lower or nil capital gain tax.
Let us understand this with an example. Suppose Priya has booked a Rs. 2 lakh long-term capital gain (LTCG) during the earlier part of the financial year by redeeming a part of her equity mutual fund investments. Due to the current stock market correction, Priya’s remaining equity mutual portfolio has a short-term capital loss (STCL) of Rs. 1 lakh.
Priya can do tax harvesting by redeeming the remaining equity mutual fund portfolio and booking an STCL of Rs. 1 lakh. The next day, Priya can buy back the same equity mutual funds. Priya’s purchase price will be reset to the current NAV at which she buys back the mutual fund units.
Let us look at how Priya’s capital gains will be taxed.
Long-term capital gain = Rs. 2 lakh
Long-term capital gain exemption from taxation during a financial year = Rs. 1.25 lakh
Long-term capital gain taxable = Rs. 75,000 (Rs. 2 lakh – Rs. 1.25 lakh)
Short-term capital loss = Rs. 1 lakh
Priya can use a part of the Rs. 1 lakh STCL to offset the taxable Rs. 75,000 LTCG
Taxable LTCG = Nil (Rs. 75,000 STCL used to offset Rs. 75,000 LTCG)
The remaining Rs. 25,000 STCL can be carried forward for the next 8 assessment years to offset any future capital gains.
Thus, with tax harvesting, Priya reduced her taxable capital gains to nil, resulting in no capital gains tax. Without tax harvesting, Priya would have to pay a LTCG tax of Rs. 9,375 (12.5% on Rs. 75,000). So, Priya saved Rs. 9,375 in taxes with tax harvesting.
Rules of capital gains taxation
To make the best use of tax harvesting, you need to understand the rules of capital gains taxation for equity mutual funds and equity shares as follows:
- The short-term capital gains (STCG) are taxed at 20%. Long-term capital gains (LTCG) of up to Rs. 1.25 lakhs are exempt from taxation every financial year. The incremental LTCG is taxed at 12.5%.
- A short-term capital loss (STCL) can be used to offset short-term capital gain (STCG) and long-term capital gain (LTCG). A long-term capital loss (LTCL) can be used to offset only long-term capital gain (LTCG).
- Unused capital losses in any financial year can be carried forward for up to 8 assessment years to offset capital gains in future. Capital losses can be carried forward only when the Income Tax Return (ITR) is filed before or on the due date for filing the tax returns.
How to make the most of tax harvesting?
Let us look at various scenarios to understand how one can make the most of tax harvesting.
Only capital gain
Consider a scenario where you have only long-term capital gains (LTCG) and no capital losses. You can book LTCG up to Rs. 1.25 lakh in a financial year as it is exempt from taxation. The maximum LTCG tax saved will be Rs. 15,625 (12.5% of Rs. 1,25,000). The strategy will work in a rising market or bull market.
If you are a long-term investor, you must reinvest the redemption proceeds the next day. The acquisition cost will be reset, and the holding period will start afresh.
Capital gain and capital loss
Consider a scenario in which you have capital gains on some investments and capital losses on some investments. The capital loss can be booked to offset capital gains booked. You can use the capital loss to offset any LTCG only after the first Rs. 1.25 lakh, as it is exempt. 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. The strategy is suited for a volatile market.
Only capital loss
Suppose you have started investing in the last 1-2 years. Due to the ongoing Iran War, your portfolio must be in a loss. You can book the capital losses and reinvest the next day. Capital losses can be carried forward to set off capital gains in future years. The strategy is suited for a falling market.
Should you do tax harvesting?
Tax harvesting is optional. While it helps save capital gains tax, long-term investors must reinvest the redemption proceeds on the next day. Failure to do so will result in disruption of long-term compounding and missing financial goals. Tax harvesting works on a financial year basis. Hence, if you plan to go for it for this financial year, you must complete the redemption and reinvestment process before or by 31st March 2026. The process can be repeated every financial year.
The tax harvesting process requires time and effort. In such a scenario, if the capital gain tax amount being saved is small, some investors give it a pass as they don’t consider it worth the time and effort involved. Use tax harvesting to your advantage for short-term capital gain tax benefits, but not at the cost of your long-term financial goals.
