What is tax-loss harvesting? Know key details to save money on income tax

The investors often face the risk of losing money while dealing with capital market instruments like equity shares. No investor likes to lose money in stock trading or the investments in mutual funds. But, if you have seen your money depleting due to market conditions there is a way out to compensate for this loss. You can use the unrealised loss on investment in equity instruments like stocks to reduce your income tax liability.

To put it simply, if you have unrealised losses in your investments in stocks and mutual funds, you can set off these losses against realised profits, which is generally known as capital gains. This helps to reduce the tax liability on the resalised profits from liquidating stocks or mutual fund investments, which attract capital gains tax.

The principle of utilising unrealised losses in certain asset classes against the gains is known as tax-loss harvesting. Apart from reducing your tax liability, tax-loss harvesting also helps you to rebalance the portfolio in alignment with your financial goals.

If you also have loss-making equity instruments in your portfolio, this might well be an opportunity to save more money while filing the Income Tax Return for FY 2023-24.

Here’s how tax-loss harvesting works

Tax-loss harvesting involves utilising the losses in investments in capital market instruments against the capital gains from the sale of certain assets in a financial year. Before understanding how tax-loss harvesting works, it is important to know the taxation on capital gains.

In India, short-term capital gains (STCG) on listed equities are taxed at 15%, whereas long-term capital gains (LTCG) of over ₹1 lakh are taxed at 10%. Assets held for up to 12 months will attract STCG while LTCG will be imposed if the duration is above this period.

Let’s understand this through an example

Now, suppose you made a short-term capital gain of ₹60,000 in a financial year. Your tax liability on this earning would be ₹9,000 i.e. 15% of ₹60,000.

However, if there are stocks in your portfolio that have incurred losses you can utilise that to reduce your tax liability. For example, you hold stocks with unrealised losses of ₹25,000 in your portfolio. You could use this loss to offset against the STCG after which your taxable amount will be ₹35,000 (₹60,000 - ₹25,000).

This way, you will be required to pay only ₹5,250 instead of ₹9,000 as STCG tax. The transactions made for tax-loss harvesting need to be declared appropriately while filing the ITR.

Most traders opt for tax-loss harvesting towards the end of the financial year after having examined the yearly performance in their portfolio and its effect on the total taxable amount from capital gains.

Key factor to note to set off losses against STCG and LTCG

It is important to note that long-term capital losses can be set against only long-term capital gains. Similarly, short-term capital losses can be set off against short-term capital gains. You cannot set off long-term capital losses against short-term capital gain.

While tax-loss harvesting allows you to save on tax liability and maintain a balanced portfolio, selling securities at a loss should be in line with your investment approach and risk appetite.

Is tax-loss harvesting allowed in India?

The income tax framework in India does not explicitly disallow tax-loss harvesting. However, you must consult your chartered accountant or a tax expert before opting for this tax-saving tool.

The sale and repurchase of stocks, solely with the motive of tax evasion by showing a loss, might invite scrutiny of the Income Tax Department.

To conclude

Tax-loss harvesting could be a rewarding option to save tax while used judiciously. This can also help to recalibrate your investment portfolio. The taxpayers planning to utilise this tool should understand the nuances of this method and must adhere to income tax laws to avoid penal action.