To harvest something means to pick or collect it. You could do the same in investing: Tax-loss harvesting is the selling of stock/mutual funds at a loss to offset a capital gains tax liability, and normally such investments are bought back to maintain the same asset allocation/portfolio.
When one earns profits on sale of capital assets, it is taxed as long-term capital gains (LTCG) or short-term capital gains (STCG) based on the holding period. The tax on such profits can be cut down to some extent using a sophisticated tax planning mechanism known as tax-loss harvesting.
Say, you invested Rs. 6 lakh in listed shares and Rs. 3 lakh equity oriented mutual funds in April 2018. The value of the shares is Rs 4.5 lakh in April 2020 and the value of the mutual funds is Rs. 5 lakh. You want to liquidate the mutual funds. The LTCG on redemption of MF is Rs. 2 lakh (Sale value Rs. 5 lakh – Cost of Rs. 3 lakh). Of this, Rs. 1 lakh is exempt and you pay 10% plus cess of 4% as LTCG tax i.e. Rs 10,400.
Prior to 31 March 2018, there was no tax on LTCG on shares and equity-oriented mutual funds; therefore, long term loss on such transactions was considered as a dead loss. After 31 March 2018, the scenario changed; profits/gains on long-term shares or equity-oriented mutual funds are now taxable in excess of Rs. 1 lakh.
Every coin has 2 sides. The positive side to this tax provision is that if you have incurred a long-term capital loss on sale of shares or equity-oriented mutual fund units, then you can set them off against any LTCG.
So, in the above example, even though you want to keep holding the shares for the long term, for the purpose of tax planning you sell the shares and re-invest the sale proceeds in the same shares within the next two to three days. This sale and reinvestment is a legal transaction and does not affect your investment amount or returns generated. The Rs. 1.5 lakh long-term capital loss (LTCL) on sale of shares can be set off against the LTCG of Rs. 2 lakh on redemption of the MF and the balance LTCG of Rs. 50,000 being less that Rs. 1 lakh is exempted. Thus you pay no tax.
Also, in case losses from the sale of capital assets exceed the gains from such assets after setting off losses and gains of a particular year, you can carry forward such losses for setting off in later years up to eight assessment years. However, keep in mind that losses for a year cannot be carried forward unless that year’s return has been filed before the due date.
It is pertinent to note that LTCG can be set off against LTCL and short-term capital loss (STCL), whereas STCG can be set off only against STCL. There is no asset class restriction on the set off. Hence losses in equities can be set off against gains in debt, real estate or gold.
Let us consider the case of Rakesh, for instance. During the year, Rakesh sold a plot of land he had purchased for Rs. 1 lakh in April 2001 for a price of Rs. 5 lakh. The cost of acquisition after indexation benefit is Rs. 3.17 lakh. The LTCG on this sale after benefit of indexation is Rs 1.83 lakh. What action can Rakesh take to reduce his tax liability in this case? Also, eight months ago, he had purchased 1,500 listed shares in Company A at Rs. 200 per share. The share is now trading at Rs. 20 each. Is any action required for these shares?
Since Rakesh has sold the land he has held for more than 24 months, the sale is liable to LTCG tax. The tax on LTCG of Rs. 1.83 lakh will be Rs. 38,064 (20% LTCG tax plus 4% cess).
Suppose Rakesh does not want to buy a house or invest this amount in capital gains bonds of the government, he can save tax by selling off the 1,017 shares of Company A and booking loss of Rs 1,83,060 (sale value of Rs. 20,340 – cost of Rs. 2,03,400) which can be set off against LTCG of Rs 1.83 lakh. Thus, the tax liability will be nil. Rakesh can carry forward STCL of Rs. 60 and set it off against capital gains in the next eight years.
Also, if Rakesh wants to continue his holdings in company A, he must reinvest the sale proceeds of Rs 20,340 in Company A’s shares within the next two to three days. Thus, he will continue investment holdings and also save on tax.