Tax Loss Harvesting – Everything You Should Know

What is Tax Loss Harvesting?

Tax loss harvesting is setting off capital gains tax arising from the sale of capital assets at a profit. The taxpayers can sell another capital asset at a loss and offset the losses from that sale to save or reduce the tax liability arising from the capital gain. To offset the losses from the capital asset sold at a loss, taxpayers must purchase another asset with the amount realized. Taxpayers generally use this strategy to save taxes on short-term capital gains as they are taxed at a higher rate. However, it can be adjusted against both short-term and long-term capital gains. Long-term capital gains of more than 1 lakh are charged to tax at 10% without the benefit of indexation, and short-term capital gains are charged to tax at 15%.

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How Does Tax Loss Harvesting Work?

Under tax loss harvesting, most investors follow this strategy, identify the loss-making and profit-making assets, and offset them against each other. It starts with selling an asset or a fund that is constantly declining and has lost most part of its value and is not likely to rebound anytime soon. In that case, the individual can sell that asset and offset the loss against the profits made from selling another asset. The amount of loss can also be used to buy another asset, stock, or fund. Although it doesn’t zero down your loss, it can help save a significant amount of loss.

Here are a few simple steps for tax loss harvesting -

• Identify the loss-making investments by regularly monitoring your portfolio.
• Sell the loss-making investments and record the capital loss.
• Reinvest the funds realized in a similar asset.
• Lastly, claim the losses on your tax return and complete the process of tax loss harvesting.
• While long-term capital gains can be adjusted against long-term capital losses, short-term capital gains can only be adjusted against short-term capital losses.

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Deducting Business Expenses

When you earn income from trading, you can reduce your taxable profit by claiming expenses directly related to generating that income. These expenses are called business expenses. If your trading results in a loss, you can carry forward these expenses to offset future profits.

Common business expenses for traders include:

• Trading-related charges: brokerage, exchange fees, etc.
• Operational costs: internet, phone bills for trading-related calls.
• Equipment depreciation: computers, electronic devices used for trading.
• Office expenses: rent for a trading space, if applicable.
• Professional fees: salaries, consultant fees, advisory charges.
• Information costs: books, magazines related to trading.

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What are the Advantages of Tax Loss Harvesting?

Here are some advantages of tax loss harvesting and how it can help taxpayers save tax -

• Postpone paying your tax liabilities - Most investors don’t plan their exit time before investing. If you plan on investing for 10 years or more, you can achieve time value savings. You can also get the benefit of long-term capital gains and pay less taxes on your investments. You can also postpone your tax liability by increasing the holding period of your investments.
• Cross-Asset Benefits for Diverse Portfolio - Tax loss harvesters can keep a diverse portfolio and get cross-asset benefits. The taxpayers can set off the tax liability of lower tax asset classes against the tax liability of higher tax asset classes. The taxpayers can also offset the loss incurred on selling one asset from the profit earned on selling another. This helps reduce the overall capital gains tax liability.
• Investment Benefits for Short-Term and Long-term - You can avoid paying STCG at 15% through tax-loss harvesting. You can set off your short-term losses against your short-term gains. After some time, if these investments turn into long-term assets, your tax liability will be calculated at 10%, even if these become profitable in nature.

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Example of Tax Loss Harvesting

Tax loss harvesting refers to the practice of selling a security that has incurred a loss to offset the capital gains that are subject to tax. Here’s an example related to equity.

Arjun earned Rs.1,00,000 in Short-term capital gains during the current year. He has to pay a 15% tax on this amount, i.e. Rs.15,000.)

Now suppose, Arjun already holds stocks having an unrealized loss of Rs.60,000. Arjun can sell these stocks at a loss and set it off with the short-term capital gain. Now, he will have a capital gain of Rs.40,000 (Rs.1,00,000 - Rs.60,000). Therefore, the tax to be paid will be 15% of Rs.40,000, i.e., Rs.6,000.

Therefore, Arjun would have saved Rs.9,000 (Rs.15,000 - Rs.6,000) as tax by following the above process, which is known as tax loss harvesting.

The process does not end here. Arjun can also buy the stocks he sold at a loss at the same price immediately after selling. This process further ensures a win-win situation for Arjun.

Here’s an example -

Suppose Arjun has a long-term capital gain of Rs.5 lakh. He sells his stocks after holding them for more than a year. Then, he will be required to pay tax @10% on the profit (Rs.5 lakh - 1 lakh = Rs.4 lakh). LTCG of upto Rs.1 lakh are exempt from tax. Therefore, the tax to be paid by Arjun is Rs. 40,000 (10% of 4 lakh).

Suppose he has more stocks with an unrealized loss of 3 lakhs. He sells these stocks in March and realizes the loss. He immediately purchases the same stocks at the same price. Now, the realized capital gains of Arjun are (Rs.5 lakhs - Rs.3 lakhs), Rs.2 lakhs. Since it is a long-term capital gain, he has to pay 10% tax on Rs.1 lakh (Rs.2 lakh - Rs.1 lakh) since LTCG is exempt upto Rs.1 lakh. In this process, Arjun managed to save Rs. 30,000 in taxes (Rs.40,000 - Rs.10,000).

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Things to Know Before Engaging in Tax Loss Harvesting

• Tax loss harvesting refers to the process of selling some assets as a loss to set them off with gains on other assets. However, there is no guarantee that these losses will be recovered.
• Long-term capital gains can be set off only against long-term capital losses. On the other hand, short-term capital gains can be set off against both STCG and LTCG.
• Before deciding to do tax loss harvesting, make sure you calculate your tax liability carefully.
• When reinvesting the proceeds from the loss-making trade, be cautious not to take on too much risk in an attempt to recoup the losses. Always consider your portfolio's risk-return profile.
• Tax loss harvesting should not be used as an investment strategy but only for tax-saving purposes.

We hope this guide helped you understand the benefits of tax loss harvesting. If you need further assistance on how to implement tax loss harvesting strategies effectively, our online CAs are here to help you optimize your tax savings. Don’t wait for the last date to file ITR– get help from our online CA service today and make the most of your investments. Book your eCA now!

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