What is Tax loss harvesting? How does it work?

Tax loss harvesting is the timely sale of loss-making securities to offset the amount of capital gains taxes owed from the sale of profitable assets. This strategy is used to preserve the value of an investor's portfolio while reducing taxes by limiting short-term capital gains, which are generally taxed at a higher rate than long-term capital gains.

Understanding the functioning of tax loss harvesting

Capital gains tax is levied on profits from the sale of shares and equity funds in India. The applicable tax rate is determined by the period the investment is held prior to sale, known as the holding period. Here's an explanation of how capital gains tax applies to stocks and mutual funds in India:

Long-term capital gains (LTCG): For applicable investments held for more than one year, a flat tax of 10% is levied on LTCG exceeding Rs. 1 crore in the financial year. It is important to note that the benefit of indexation, which takes into account inflation, does not extend to LTCG on equity funds and shares. However, LTCGs up to INR 1 lakh in a financial year are tax exempt.

Short-term capital gains (STCG): STCG on shares and equity funds of investments held for one year or less must be given based on the personal income tax rate.

And the most important thing is that you can compensate for the loss of capital, thereby reducing the risk of loss.

Benefits of Tax Loss Harvesting

Below are some of the benefits of tax loss harvesting and how taxpayers can save on taxes:

• Defer your tax obligations – Most investors do not schedule an exit before investing. You can save time and money by investing for ten years or longer. You can also pay less tax on your assets and benefit from long-term capital gains. By extending the investment holding period, you can postpone your tax liability.
• Cross-asset benefits for a diversified portfolio – Tax-loss savers can benefit from cross-asset benefits and maintain a broad portfolio. Taxpayers can offset the tax liabilities of lower-taxed asset classes against the tax liabilities of higher-taxed asset classes. Taxpayers can also deduct the loss from the sale of one asset against the profit from the sale of another asset. This reduces the total amount of capital gains tax.
• Investment benefits in short and long term – You can prevent paying a 15% short-term capital gains tax by utilizing the tax loss. Short-term gains can be offset by short-term losses. Despite these investments possibly becoming profitable in the future and turning into long-term assets, you will still owe 10% in taxes.

Tax Loss Harvesting Example

Here is a concise example of tax loss harvesting:

Let's say you have two stocks:

Stock A: Bought for 50 USD per share, now worth 40 USD.

Stock B: Bought for 80 USD per share, now worth 70 USD.

You sell Stock A at a loss of 10 USD per share, totaling 1,000 USD. This loss can be used to offset capital gains, reducing your tax liability. You reinvest the proceeds and can also carry forward any excess losses to future years.

Bottom Line

Tax profit and tax loss harvesting is a simple and effective way to reduce the taxes you pay on your stock investments. Remember that you have to reinvest the money once the redemption amount is in your account, otherwise you risk breaking the complicated journey.

FAQs

Q. How does tax-loss harvesting work?

A. Tax-loss harvesting generally works like this: You sell an investment that's underperforming and losing money. Then, you use that loss to reduce your taxable capital gains and potentially offset up to $3,000 of your ordinary income.

Q. Can I sell and buy on the same day for tax harvesting?

A. Well, there is no explicit regulation in India that disallows tax loss harvesting. Individuals can buy those same stocks and continue to hold them, immediately after selling them at a loss.

Q. What are the benefits of selling stock at a loss?

A. Taking the loss could allow you to get your portfolio back on track more quickly—and potentially offset capital gains and/or ordinary income.

Q. When to sell stock for tax-loss?

A. It's generally better to take any capital losses in the year for which you are tax-liable for short-term gains, or in a year in which you have zero capital gains because that results in savings on your total ordinary income tax rate.

Also Read: Different Types of Mutual Funds in India: You should know