Tax Harvesting Explained with Examples

Stocks and equity mutual fund investors need to know about taxation before they begin their first investment. Any profit or returns earned on their investment in equity is categorized under short and long-term capital gains.

Capital gains tax (CTG) was first introduced by Shri T.T. Krishnamachari, the finance minister of India, during the Union budget 1956-57.

However, finance minister Arun Jaitley later proposed taxation on dividend distribution income and capital gains on equity mutual funds in 2018.

According to this, a 10% long-term capital gain (LTCG) is taxed on equity mutual funds held for more than a year. But this is only applicable if the returns exceed Rs. One lakh-per-annum-threshold.

Understanding tax harvesting allows investors to make use of this Rs. One lakh tax-free limit and reduce their LTCG tax liability.

What Is Tax Harvesting in India?

As retail investors, you incur capital losses or gains depending on when you are selling or redeeming your stocks or mutual fund investments. The taxation on equity is done based on the duration for which you held on to the investment.

For instance, if you hold a stock or a mutual fund for less than a year, it will be liable for short-term capital gain taxation. It is about 15% of the gains you generate.

But for any investment held for more than a year, the taxation will be under long-term capital gains tax at 10%.

With the tax harvesting strategy, investors can partially sell their mutual fund holdings and book or reinvest that amount in the same fund. This is an effective way of tax planning to reduce the effective tax on your equity investment gains.

If you don’t do this, you may pay more taxes than needed. If an investor makes losses on one investment and profit on another, they will not be able to offset the gains with the losses and lower their tax liability without tax harvesting.

Note: Long-term capital loss can only be offset against the long-term capital gain and short-term loss with short-term gains.

Types of Tax Harvesting in India

Indian investors can harvest taxes according to two main strategies:

Tax gain harvesting

The capital gain harvesting strategy allows you to lower your tax liability as you can offset your losses against any profit you made.

Tax loss harvesting

Indian investors can use this strategy to reduce their long-term capital gains tax on investments by selling their realized losses.

Both strategies help lower your tax liabilities. However, while tax gain harvesting allows you to sell your investments whose value is appreciated, in tax loss harvesting, you sell your losses in a financial year (FY).

However, these only apply to long-term investors, since new investors may not cross the Rs. One lakh limit in a year after investing.

How Is Tax Harvesting Done Properly in India?

For investors with larger equity portfolios, it is possible to witness incremental returns. It is the additional gains your investment generates on top of the previous year's returns. This is how mutual fund investors in India can generate long-term wealth.

But this also increases your tax liability on the gains made.

So, you need to harvest your taxes in a way that your gains in a financial year do not exceed Rs. One lakh limit.

You do this by selling a part of the mutual fund investment and booking your long-term capital gains. Then, you need to reinvest the amount in the same fund.

Scenario 1  -  Tax Gain Harvesting

For instance, let’s assume you invested Rs. 200000 in an equity fund on 22nd Feb 2022, and its value became Rs. 224000 on 22nd Feb 2023. In that case, upon redemption, you would gain Rs. 24000.

We are assuming an average of 12% annual return generated by the mutual fund, which is an average return of the Nifty 50 index benchmark in the past 10 years.

However, since this is a lot less than Rs. One lakh, your tax liability would be zero since, after a year, it will fall under long-term capital gain taxation.

In the next step, you need to reinvest the entire amount, which is Rs. 224000, immediately in the fund after redeeming. You do this to avoid breaking the compounding of your returns. This is also the reason that you need to invest in the same mutual fund from which you made the redemption.

Now, let’s assume that this investment value increased to Rs. 250000 in the next year, i.e. 22nd Feb 2024. Now, when you redeem this, your gains will be Rs. 26000, which is still within the LTCG non-taxable limit.

Similarly, continuing the above method, in the third year, the value will be Rs. 280000; in the fourth year, it will be Rs, 313600.

As you can see, in four years, your tax liability is only about Rs. 33,600.

What Would Have Happened without Tax Harvesting?

Had you not redeemed and reinvested this amount, your tax liability on the initial principal amount of Rs. 200000 would have been Rs. 113600 (Rs 313600-200000).

This would have incurred taxation of Rs. 1360 [(Rs 113600-100000) x10%] on the capital gain over the Rs. One lakh limit. This may not seem like a big amount, but imagine if the corpus was Rs. Five lakhs or more.

In that case, the capital gain would have easily crossed the Rs one lakh limit in two years with a tax liability of about Rs. 5000.

So, small investors, who opt for monthly SIPs, can benefit from the tax harvesting strategy after redeeming units every 12 months and reinvesting them.

Scenario 2: Tax Loss Harvesting

The above scenario was presented to give you an idea of tax gain harvesting. But what happens in case of losses?

Let’s assume the same Rs. 200000 investment on 22nd Feb 2022 saw a capital loss of Rs. 20000.

By selling this investment on 22nd Feb 2023, you book the loss and reinvest the money.

Now, this long-term capital loss can be offset with any long-term capital gains you made during this year. If your capital gains are not sufficient to offset the amount of loss in that year, then you can offset it with eight consecutive assessment years following that.

So, now, you can redeem your long-term equity mutual fund investment even after two years from the year you incurred the loss.

Let’s assume you can generate a profit of Rs. 1.5 lakhs in the 2nd year. Now, you have capital gains of Rs. 5000 that exceed the long-term capital gain limit.

But you can offset this with the previous Rs. 20000 loss you incurred in FT 2023 while calculating your taxes. So, your effective long-term capital gain will become Rs. 150000-Rs. 20000 = Rs. 130000.

Now, you need to pay LTCG tax on the excess Rs. 30000, which would be Rs. 3000 only.

Conclusion

Both tax gain and tax loss harvesting have their own advantages. This is especially relevant amidst the recent market crash.

If you have made capital gains in the ongoing financial year 2022-2023, this current market scenario poses an opportunity to reduce your taxable income.

Just follow the strategies mentioned above, or take help from authorized investment advisors to help you in this.

But make sure to reinvest the amount right after redemption to avoid breaking the compounding effect of your mutual fund scheme.