What is Tax Loss Harvesting? Benefits, Strategy & How It Works

Through tax loss harvesting, investors sell off underperforming assets to offset capital gains to reduce their tax burdens. This technique allows for significant tax reduction while still maintaining an investment strategy, which is especially useful when trying to maximise after-tax returns in today’s volatile markets. In this blog, we will discuss what tax loss harvesting is and some of the important factors you should consider. Let’s get started!

What is Tax Loss Harvesting?

Tax loss harvesting is an investment strategy where you deliberately sell securities at a loss to offset capital gains from other investments. The overall concept is simple: losses from one investment can offset gains from another investment, reducing taxable income.

Here’s a simpler breakdown: selling an investment at a higher price than what you paid for it leaves you with taxable capital gain. To offset these taxes, you can sell another investment at a loss. That capital loss cancels out some or all of your taxable gains. This strategy becomes particularly valuable when you have significant capital gains from successful investments but also hold underperforming assets that have declined in value.

Capital losses can be offset against capital gains in the same category, per Indian tax laws. Short-term capital losses can offset both short-term capital gains and long-term capital gains, while long-term losses can offset only long-term capital gains. This mechanism is what makes tax loss harvesting possible.

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How Does Tax Loss Harvesting Work?

Let's understand this with an example: An active stock market investor had the following capital gains from listed equity shares:

• Short-Term Capital Gains (STCG): ₹5,00,000
• Long-Term Capital Gains (LTCG): ₹12,00,000

The investor also has certain underperforming shares, which, if sold, would leave him with a short-term capital loss of ₹1,50,000.

Based on the current tax rates and exemptions, here’s how the investor’s tax loss harvesting would play out.

Before Tax Loss Harvesting:

After Tax Loss Harvesting:

By selling loss-making shares and using tax loss harvesting, the investor reduced his tax liability by ₹30,000, fully within the framework of Indian income tax laws.

Tax Loss Harvesting Process

The process of tax loss harvesting involves the following key steps: identifying losses, executing the sale, and reinvesting proceeds. Here’s a breakdown:

• Check your Portfolio: Identify which investments are trading below the price at which you purchased them. These will be your baseline to determine which losses to harvest.
• Determine Potential Benefit: If you harvested each of these losses, determine how much tax you are going to save by using them against your capital gains from other investments.
• Implement the Sale: Sell the securities at a loss before the year’s end so that you can realise that loss and claim it in the tax year.
• Reinvest: Buy similar or the same securities with the proceeds so that you can still maintain your investment plan and desired asset allocation.
• Create a File: Keep a record of the transactions with the date of purchase, the amount, and the tax implications of the transaction for future reference and compliance.

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Key Compliance Requirements for Tax Loss Harvesting

According to Section 74 of the Income Tax Act, the following are things to keep in mind when harvesting tax losses:

• Capital losses that aren’t offset in your current assessment year (AY) can be carried forward for eight more assessment years.
• However, this carry-forward is valid only if you’ve filed your income tax returns (ITR) within the due date for the current AY.
• Any unadjusted capital losses carried forward can only be offset by eligible capital gains.

Things to Consider in Tax Loss Harvesting

Several crucial factors determine the effectiveness of your tax loss harvesting strategy:

• Asset Categorisation: Determine if your investments are short- or long-term based on their holding periods. For example, equity shares have a short-term classification, if held for a maximum of 12 months and a long-term, if held for greater than 12 months.
• Transaction Costs: Assess all relevant costs, including brokerage and securities transaction tax. For tax loss harvesting to be beneficial, the tax savings have to be greater than these transaction costs.
• Wash Sale Considerations: India does not have specific wash-sale rules as some other countries do, but the action of buying back identical securities immediately can raise questions as to the substance behind the transaction, potentially attracting scrutiny from tax authorities.
• Portfolio Balance: Do not lose sight of your investment objectives by tax loss harvesting solely for tax considerations. Remember, the primary objective is wealth creation, and this can only be achieved by sound investing.
• Timing Requirements: For a tax loss to be claimed in the current financial year, relevant transactions must be completed by the financial year end.
• Documentation Needs: As with everything tax-related, holding accurate records is crucial. This includes dates and amounts for all the relevant transactions.

Benefits of Tax Loss Harvesting

There are several advantages of tax loss harvesting. Some of them are:

• Immediate Tax Savings - It helps reduce your tax liability in the current year by offsetting the capital gains with some losses, unlocking additional funds you can reinvest or use in other ways.
• Carry Forward Losses - The eight-year bracket means you have plenty of scope to offset your losses against gains.
• Improved Portfolio Management - Making routine reviews of underperforming investments helps you identify assets that no longer align with your investment goals.
• Enhanced returns - You can reinvest the funds saved on tax to compound your savings and significantly improve long-term wealth accumulation.

To Conclude

When executed responsibly, tax loss harvesting can be an invaluable strategy to balance your investment losses and gains. It can help you deliver tax benefits in the short term and align with your investment goals as well. But make sure to remember that tax implications should only serve to complement your investment strategy, never dictate it.

Frequently Asked Questions

Can I use short-term losses to offset long-term gains?

Yes, but there are specific rules. Capital losses are first adjusted against gains of the same type, short-term losses against short-term gains, and long-term losses against long-term gains. If there is still a balance loss remaining, it can then be set off against the other type of capital gain as allowed under tax laws.

What happens if my losses exceed my gains in a financial year?

If you have losses greater than your gains in a financial year in India, you may carry forward the excess loss up to 8 years to offset future capital gains. Long-term capital losses can only be adjusted against income from the LTCG. i.e., long-term capital gains. You must file your tax return on time to carry forward the loss.

Can I immediately repurchase the same stock after selling it for tax loss harvesting?

Yes, but you must do so in a measured manner. Though Indian law does not have explicit wash-sale rules, buying back identical securities immediately may not be viewed favourably and could lead to doubts about the nature of the transaction. Consider waiting or buying into different but similar securities.

Can I use tax loss harvesting for mutual funds?

Yes, it is possible to use tax loss harvesting for mutual funds by selling mutual fund units at a loss to offset other investment gains.

However, there are a few rules that apply to mutual funds:

• Long-term losses can only offset long-term gains; short-term losses may offset both short-term and long-term gains.
• If your losses exceed your gains, you may carry forward losses for 8 years.

Timely filing of your Income Tax Return (ITR) is essential if you wish to carry forward losses.