As you sow, so shall you harvest

Every taxpayer wants to reduce their income tax burden. In addition to the use of provisions such as Sections 80C and 80D (which exempt certain types of investments and health insurance premiums from being taxed, up to certain limits), there are a couple of perfectly legal techniques you can use to reduce your taxable income.

In this article, we’ll discuss two such techniques that are relevant to investors: tax harvesting and tax loss harvesting.

Tax harvesting

In India, capital gains fall into two broad categories for the purposes of taxation: long-term capital gains (LTCGs) and short-term capital gains (STCGs). For capital gains to qualify as LTCGs, they must derive from investments that were held for longer than a certain period; this period is either 12 months or 24 months, depending on the asset class invested in.

Now, following the Union Budget 2024, LTCGs of up to ₹1.25 lakh per financial year on domestic equities* and equity-oriented mutual funds* are tax-exempt **. For such securities, the holding period for capital gains to qualify as LTCGs is 12 months, and the LTCG tax rate is 12.5%.

So for example, if your LTCGs on such securities in a given year add up to ₹1.5 lakh, then you’ll need to pay tax only on ₹25,000, as the rest will be tax-exempt.

The technique of tax harvesting makes tactical use of this exemption to reduce your long-term tax burden. Let’s understand how it works with a concrete example.

Suppose you wish to invest a lump sum of ₹5 lakh in a domestic equity-oriented mutual fund scheme right now. Let’s assume that this scheme delivers 12% annualised returns. You plan to withdraw your funds from this scheme after 5 years (perhaps because you have a major expense you’re expecting at that time).

The table below shows how your money would grow without tax harvesting.

If you were to simply cash out your funds at the end of 5 years, you would make realised gains amounting to around ₹3.81 lakh. Assuming that there were no other LTCGs that year, and after subtracting the tax-exempted amount of ₹1.25 lakh, you’d have to pay taxes on ~₹2.56 lakh. At the current rate of 12.5%, that would work out to an LTCG tax bill of around ₹32,000.

However, if you were to make use of tax harvesting, what you would do is sell your fund units every 12 months, and then immediately reinvest the liquidated amount in the same scheme. Why? Because by doing so, you’ll be able to take advantage of the annual LTCG tax exemption limit of ₹1.25 lakh. The table below sheds more light on this idea.

As you can see, in no financial year do your realised capital gains exceed the LTCG tax exemption threshold. As a result, at the end of five years, you’ll save around ₹32,000 in taxes! Although transaction costs and other expenses might eat into this amount, you’re still likely to end up saving a significant amount of money by making use of tax harvesting.

Also, it should be noted that since tax harvesting hinges on the LTCG exemption limit of ₹1.25 lakh, it can’t be used to reduce your STCG tax liability.
Tax loss harvesting

Another technique that can reduce your income tax is something called tax loss harvesting. This technique takes advantage of the fact that you have to pay tax only on your net capital gains per financial year.

This means that if you have some underperforming investments, then booking a loss on them will allow you to “offset” your capital gains, thus reducing your net capital gains and tax liability.

For instance, consider the first scenario above, where you didn’t make use of tax harvesting and had taxable LTCGs of ~₹2.56 lakh after 5 years. Suppose that at the end of that 5-year period, one of the investments in your portfolio (let’s call it Scheme X) had unrealised long-term capital losses of ₹1 lakh.

If you were to implement tax loss harvesting, you would sell all your units in Scheme X and realise a loss of ₹1 lakh. As a result, your net taxable LTCGs would reduce by ₹1 lakh, for a total of ~₹1.56 lakh. This would result in a tax bill of ~₹19,500, which is around 39% lower than the original tax bill of ~₹32,000!

Note that when using tax loss harvesting, it is advisable to sell poor performers that you wish to eliminate from your portfolio anyway. Otherwise, if you plan to buy back a security soon after selling it, there’s always the risk that it might make major upward movements right after you sell it, forcing you to buy it back at a higher price.

Also, tax loss harvesting can be used to reduce net STCGs as well as net LTCGs. In fact, short-term capital losses can be set off against long-term capital gains as well.

Making taxes less taxing

So, there you have it: two techniques that should be part of your arsenal of investment tactics. If you don’t make use of them, you might be leaving money on the table, so make sure you examine your portfolio at regular intervals to spot harvesting opportunities.

To reiterate: tax harvesting reduces your tax bill through strategic reinvestment and the use of annual exemptions. Tax loss harvesting, on the other hand, offsets gain by selling loss-making investments, reducing net gains and tax liability; it is best used towards the end of each financial year to rebalance your portfolio while also enjoying tax benefits.

Once again, before you implement these techniques, make sure you’re factoring in all the various expenses that may be involved in trading securities, such as transaction costs, expense ratios, and exit loads.

Don’t hesitate to reach out to your CA for advice on this front. As for advice on the investment front, our experts are always there to guide you: simply click here to get in touch with us.

*Securities Transaction Tax (STT) needs to be paid on acquisition as well as sale.

** Securities Transaction Tax (STT) needs to be paid on redemptions/transfers.

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