An Introduction to Tax-Loss Harvesting


What if you could take advantage of a fall in the value of an asset in the portfolio? Tax-Loss Harvesting is an opportunistic way to increase your post-tax returns on investment. Previously, the long-term capital gains (LTCG) made on the sale of equity shares, and equity funds were completely tax-free in your hands.

In the 2018 Union Budget this changed and below are the revised laws:

1. There is a 10% tax on Long-term capital gains without the benefit of indexation

2. Long-term capital gains below ₹1,00,000 are tax-free 

3. Short term capital gains are taxed at 15%

What is tax-loss harvesting?

Tax-loss harvesting, also known as tax-loss selling, is the process of selling some securities at a loss and using this loss to offset the tax on the capital gains you make on the sale of other securities. Although you might not recover the entire loss, it helps reduce your losses by reducing your tax burden. 

Is tax-loss harvesting legal?

Yes, tax loss harvesting is legal as the Income Tax Department lets you offset capital gains with capital losses to reduce your tax liability. Therefore, you just have to pay taxes on the net gains. However it is important to ensure you calculate your tax liability correctly to make sure you can take advantage of tax-loss harvesting without breaking the law.

Important points to remember while using tax-loss harvesting:

1. Long term capital losses can offset only long-term capital gains. We cannot offset long term capital losses with short-term capital gains.

2. Short-term capital losses may be offset by short-term and long-term capital gains.

How does tax-loss harvesting work?

Generally done at the year-end while filing for returns, this process starts with identifying and selling an asset in your portfolio which has consistently given negative returns with low chances of recovering. These losses are then used to offset other gains in your portfolio.

For example at the end of a financial year:

Asset A- Cost - ₹2,00,000

              Held for - 400 days

              Sold at -  ₹4,00,000

              Profit = ₹4,00,000 - ₹2,00,000 = ₹2,00,000

Asset B- Cost - ₹1,00,000

              Held for - 400 days

              Sold at -  ₹50,000

              Loss = ₹1,00,000 - ₹50,000 = ₹50,000

Your profits are ₹2,00,000, therefore, making your taxable amount ₹1,00,000 as there is no tax on the first ₹1,00,000 in gains (revised rule 2. above)and you are taxed on the remaining ₹1,00,000 at 10% which is ₹10,000

On the other hand, if you use tax-loss harvesting you can use the ₹50,000 loss made on the sale of asset B to offset the gains made on asset A and show your net gains as ₹1,50,000 and since there is no tax on LTCG up to ₹1,00,000 your effective taxable amount becomes ₹50,000 thus saving you ₹5000 in taxes.

Tabular explanation of the example

The proceeds from selling an asset at a loss can be used to buy another better-performing asset. This is necessary to maintain the original asset allocation of the portfolio as well as maintains the overall risk-return profile of the portfolio.

Is Automation of tax-loss harvesting beneficial?

With Fintech becoming more and more popular due to its ability to provide high-quality services to the masses at a relatively low cost even tax loss harvesting is being automated. Traditionally it was done once or twice a year by your wealth manager and was an extremely time-consuming and slow process. Whereas now with the help of robo -advisors and software, this process can be done in real-time and can help you optimize your portfolio to reduce your tax liability and help you increase your returns.

Key Takeaways

No matter how cautious you are, markets are always bound to face short-term volatility. The fundamental drivers in an investment – valuations, interest rates, earnings growth – can't be expected to remain the same forever. So we can use this volatility to our advantage by using tax-loss harvesting to reduce our total tax liability. The money saved from Tax-Loss Harvesting can be reinvested and compounded over time to give you great returns. As they say, a penny saved is a penny earned.

Author: Team dezerv.

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