When it comes to taxes in India, most people focus on taxes deducted at source (TDS) from salaries or business income. However, taxes on investment gains, particularly capital gains, often go unnoticed because they are not automatically deducted. This can lead to an unexpected tax liability at the end of the financial year.
One effective way to minimize taxes on investment gains is tax harvesting—a strategy where investors sell loss-making stocks or mutual funds to offset capital gains, thereby reducing the overall tax liability. This method is particularly beneficial for investors who have made significant gains in a given financial year.
Understanding Capital Gains Tax in India
Investments such as equity shares, mutual funds, bonds, government securities, and debentures are classified as capital assets. The profit earned from selling these assets is subject to capital gains tax, which is categorized based on the holding period:
1. Long-Term Capital Gains (LTCG) Tax
- Applicable to investments held for more than 12 months before selling.
- Tax rate: 12.5% on gains exceeding ₹1.25 lakh.
Example: Suppose you invest ₹5 lakhs in stocks, and after two years, your investment grows to ₹6.5 lakhs. The total gain is ₹1.5 lakhs, but only ₹25,000 (₹1.5 lakhs – ₹1.25 lakh) is taxable. The LTCG tax payable is ₹3,125 (12.5% of ₹25,000).
2. Short-Term Capital Gains (STCG) Tax
- Applicable to investments sold within 12 months of purchase.
- Tax rate: 20% on the entire gain, irrespective of the amount.
Example: If you invest ₹1 lakh in a stock on April 30, 2023, and sell it on December 31, 2023, for ₹1.5 lakhs, the profit of ₹50,000 is taxed at 20%, resulting in a tax liability of ₹10,000.
Two Ways to Reduce LTCG Tax Liability
1. Selling Before Gains Exceed ₹1.25 Lakhs
Since LTCG up to ₹1.25 lakhs is tax-free, investors can strategically sell holdings before gains exceed this limit.
Example: You invest ₹5 lakhs in January 2022, and by March 2023, your investment is worth ₹5.6 lakhs. Selling at this point locks in a gain of ₹60,000, which is tax-free. However, if you wait another year and the investment grows to ₹7 lakhs, your gain is now ₹2 lakhs, and the taxable portion is ₹75,000 (₹2 lakhs – ₹1.25 lakhs). You now owe ₹9,375 (12.5% of ₹75,000) in LTCG tax.
2. Offsetting Losses with Gains (Tax-Loss Harvesting)
This strategy involves selling loss-making investments to offset taxable gains, thereby reducing the overall tax burden.
Example:
- You invested ₹1 lakh in a stock in 2021, but its value dropped to ₹80,000 in 2023, incurring a ₹20,000 loss.
- At the same time, another investment yields ₹1.5 lakhs in LTCG.
- Normally, you would pay tax on ₹25,000 (₹1.5 lakhs – ₹1.25 lakhs).
- By selling the loss-making stock, you reduce your taxable gain to ₹5,000 (₹25,000 – ₹20,000), significantly cutting your tax liability.
Reducing STCG Tax Liability
Since short-term capital gains are taxed at 20% regardless of the amount, the best way to reduce liability is by offsetting short-term capital losses against gains.
- Short-term capital losses can be set off against both short-term and long-term capital gains.
- Long-term capital losses can only be set off against long-term capital gains.
- Unused losses can be carried forward for up to 8 years to offset future gains.
The Takeaway
Tax-loss harvesting is an effective way for investors to reduce their tax liability and maximize post-tax returns. Since it requires continuous monitoring of gains and losses, it’s important to review your investment portfolio periodically and make strategic decisions. By reinvesting the redeemed amount, investors can continue compounding their returns while minimizing the tax impact.
By incorporating tax harvesting into your investment strategy, you can legally and effectively reduce your capital gains tax burden while optimizing your financial growth.