Tax Harvesting – a way to save taxes

Taxes are a thing none of us enjoy paying but usually end up bearing the burden of it knowingly or otherwise. We all are always on the lookout for options that ultimately reduce the tax burden.

If we cut straight to the point, Long Term Capital Gain on shares has been one such source of Income where taxpayers have always been looking for relief and ways to reduce their tax liability (LTCG on shares arises if they are held for more than 12 months).

Through Budget 2018, the Government introduced income tax on long-term capital gains earned on equity shares and equity-related instruments like units of the mutual fund. Any gain made on the sale of these investments, over and above Rs. 1,00,000 in a financial year, is taxable at the rate of 10% under section 112A.

If you want to pay low or no taxes, you need to ensure the gains don’t build up beyond the tax-free limit and that’s what tax harvesting is all about.

What is Tax Harvesting?

It is the strategy of selling a part of your equity (Stocks, Mutual funds, SIP, etc.) to book long-term capital gains.
Let’s understand this concept through two cases.

Case A:
Assume you have invested Rs. 5,00,000 in equity mutual funds on Feb 15, 2018 and on Feb 20, 2020 the value of this investment becomes Rs.5,90,000.

Now, if you sell your shares, your gain would be Rs. 90,000 (Rs. 5,90,000 less Rs. 5,00,000) and your tax liability will be zero. This is because any equity investment held for a period of more than 12 months qualifies as a long-term capital asset (LTCA) and gains earned on the sale of such LTCA attract tax, which must be paid only if such gains exceed Rs. 1 lakh in a financial year. This is the right time to sell these shares and avoid the tax burden.

Case B:
You invest Rs. 5,00,000 on Feb 15, 2018, in an equity mutual fund, and on Feb 21, 2021, you redeem the investment at Rs. 6,50,000. Now, your capital gain is Rs. 1,50,000 which becomes taxable as it exceeds the exempt limit of Rs. 1 lakh. Now, you will have to pay taxes at the rate of 10% of Rs. 50,000 (Rs. 1,50,000 less Rs.1,00,000).

Analysis:

Primarily, just by making an exit at the right time, you can avoid the tax burden. So, be a smart investor, and use the Tax Harvesting method, as proposed in Case A, to save taxes on LTCG.

Tax Loss Harvesting

In this method, you book long-term capital loss and offset gains in any other instruments to bring down your tax liability. 

Let’s use Case B again as an example-

Your taxable LTCG from investment in an equity mutual fund was Rs. 50,000 on Feb 21, 2021.
Let’s say, you have invested Rs. 2,00,000 on Jan 15, 2019 in HDFC Small Cap Fund. On Feb 21, 2021, your investment value is Rs. 1,84,000 and you sell it.
Your LTCL is Rs. 16,000 (Rs. 2,00,000 less Rs. 1,84,000). This loss can be set off against the LTCG that you have made in the same year i.e.,

Taxable amount = LTCG-LTCL = Rs. 50,000 less Rs.16,000 = Rs. 34,000 (Total taxable amount).

Your tax (10%) on LTCG will be Rs. 3,400.

You can set off the losses from LTCG earned in the same year or can carry forward the losses for up to 8 assessment years.

Point To Ponder-

Tax harvesting applies only if:

• The amount is invested in equity instruments for a period of more than 12 months.

• You sell the instruments before crossing the threshold limit of Rs. 100,000/- capital gains.