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Whenever you redeem your mutual funds, it generates capital gains that attract tax. The rate of taxation of the capital gains depends on the holding period of the asset. The holding period is the time period for which an individual remains invested in the fund. If the equity fund is held for more than 12 months, it is known as a long-term capital asset, similarly, if the equity fund is held for less than 12 months, it is known as a short-term capital asset. While the LTCG on equity funds is taxed are charged to tax, there are various ways in which you can avoid paying tax or minimize your tax liability on long-term capital gains on equity funds.
Equity funds refer to mutual funds in which more than 65% of the total fund value is invested in the equity shares of companies. As previously mentioned, if you redeem your equity fund units within one year, you will incur short-term capital gains, which are subject to a flat 15% tax rate, irrespective of your income tax bracket.
Long-term capital gains arise when you sell your equity fund units after holding them for more than one year. These gains, up to Rs 1 lakh per year, are exempt from taxation. However, any long-term capital gains exceeding this limit are subject to a 10% tax, without the benefit of indexation.
Long-term Capital Gains on Equity Funds can be calculated by subtracting the cost of acquisition from the sale consideration of the units of equity funds.
Mr. X invested Rs 3 lakh in an equity mutual fund on September 03, 2018. The NAV of this equity fund is Rs 50. Upon investing in the equity fund, you get 6000 units of the equity fund. He redeemed all the units of the equity fund on August 09, 2022.
The NAV as of 31 January 2021 = Rs 60.
Investment amount = Rs 60 * 6000 = Rs 3,60,000.
The NAV on 09 August 2022 = Rs 80
Investment amount = Rs 80 * 6000 = Rs 4,80,000
Value of Capital gains taxed = Rs 4,80,000 – Rs 3,60,000 = Rs 1,20,000.
LTCG upto Rs.1,00,000 is exempt. Therefore, you have to pay tax on (Rs.1,20,000-1,00,000) Rs.20,000 at a rate of 10% = Rs 2,000.
In the case of Equity Mutual Funds, Long-Term Capital Gains (LTCG) attract taxation only when your returns in a financial year surpass Rs. 1 lakh. Consequently, if your Long-Term Capital Gains from Equity Mutual Funds remain equal to or below Rs. 1 lakh in a financial year, you are exempt from Capital Gains Tax on your returns. This forms the core of the Tax Harvesting strategy employed in Equity Mutual Funds.
If you've invested a small amount, the long-term returns from your investment will most probably stay below Rs. 1 lakh, exempting you from any long-term capital gains tax upon redemption. However, as you contribute more to your investments and your returns exceed the threshold of Rs.1 lakh, your long-term capital gains will become taxable. The table below illustrates the timeline for your returns to exceed the Rs. 1 lakh mark based on various lump-sum investment amounts, assuming an annual return of 12%:
| Investment Amount | Returns after 1 Year | Returns after 3 Years | Returns after 5 Years |
|---|---|---|---|
| Rs. 1.5 lakh | Rs. 18,826 | Rs. 63,864 | Rs. 1.21 lakh |
| Rs. 2 lakh | Rs. 25,102 | Rs. 85,152 | Rs. 1.61 lakh |
| Rs. 2.5 lakh | Rs. 31,377 | Rs. 1.06 lakh | Rs. 2.02 lakh |
| Rs. 3 lakh | Rs. 37,653 | Rs. 1.28 lakh | Rs. 2.42 lakh |
As shown, for a lump-sum investment of Rs. 1 lakh, long-term capital gains exceed the Rs. 1 lakh threshold after 5 years. On the contrary, for a larger investment of Rs. 2.5 lakh, the time taken for gains to exceed Rs. 1 lakh is only 3 years.
Implementing the Tax Harvesting strategy involves selling a portion of your Equity Mutual Fund units annually to realize long-term gains and subsequently reinvesting the proceeds into the same fund.
To illustrate, consider an investment of Rs. 6 lakh in an Equity Fund on February 1, 2020, with a 12% return. On March 1, 2021, the investment returns and capital gains would be as follows:
| Lump-Sum Investment on 1st February 2020 | Rs. 6 lakh |
|---|---|
| Return Generated | 12% |
| Investment Value on 1st March 2021 | Rs. 6.75 lakh |
| Long-Term Capital Gains on 1st March 2021 | Rs. 75,305 |
Redeeming the investments on March 1, 2021, incurs no Capital Gains Tax as the gains are Rs. 75,305, below the Rs. 1 lakh limit for the financial year.
Subsequently reinvesting the proceeds of Rs. 6.75 lakh on March 2, 2021, with a 12% annual return, the investment grows to approximately Rs. 7.60 lakh by March 5, 2022. Redeeming again on March 20, 2022, with long-term gains of Rs. 84,718, incurs no tax due to the gains being below the Rs. 1 lakh limit for the financial year.
Contrastingly, if the initial investment of Rs. 6 lakh is held until March 5, 2022, the total long-term capital gains become Rs. 1.60 lakh, with taxable gains of Rs. 60,000 and a Capital Gains Tax payable of Rs. 6,000.
Tax Harvesting is applicable when investing through SIP as well, by redeeming units that qualify for long-term capital gains and reinvesting the proceeds each time.
Another tax-efficient strategy is Tax Loss Harvesting, where Long-Term Capital Losses are booked and offset against Long-Term Capital Gains from other investments, reducing the overall Capital Gains Tax burden.
For instance, an investment of Rs. 2 lakh in an Equity Mutual Fund on February 1, 2020, and a decrease in value to Rs. 1.6 lakh by March 3, 2021, results in a Long-Term Capital Loss of Rs. 40,000.
This loss can be offset against Long-Term Capital Gains in the same year or carried forward for up to 8 assessment years. If, in this scenario, Long-Term Capital Gains of Rs. 1.42 lakh are incurred from another equity fund in January 2021, the offsetting reduces the Net Taxable Long-Term Capital Gains to Rs. 2,000, resulting in a total Capital Gains Tax payable of Rs. 200.
The effectiveness of Tax Loss Harvesting is evident when there are no capital gains in the same year, but in subsequent years, the Long-Term Capital Gains of Rs. 1.5 lakh are offset against the loss incurred in 2021, thereby reducing the taxable gains and a decreased Capital Gains Tax payable on the investment.
Earlier, the long-term capital gains arising from equity funds were exempt from tax. However, after Budget 2018-19, LTCG tax was made applicable on LTCG tax arising on equity funds. Despite this, you can still invest in equity mutual funds and save a lot on taxes. Given below are some tips that can help you manage your Long-term capital gains on equity funds -
Tax harvesting is an effective strategy that can help you avoid long-term capital gains tax on equity funds upon redemption. Despite the fact that LTCG on equity funds is subject to tax, you can still minimize your tax liability. Hope this article helped you understand the various ways in which you can strategize your equity investments to avoid tax liability. If you are still confused or need help, you can reach out to our tax experts who are always here to help you every step of the way.
