What is Tax Loss Harvesting & Why is it important today?

At last bubble of the Indian Stock Market has burst and this leads to a blood bath in the market. The stocks trading in the market, whether it is Small, Mid or Large Cap are trading earlier at high value and retail investors are eager to invest in these stocks without analysis and evaluation. Since the most affected category is the retail investors, lakh-crores of capital has been eroded during the previous five months, and this stream is still continuing. The main dilemma for a retail investor is that they have suffered a huge loss and they are still holding shares and expect that market will be bullish in the long term. But there is no certainty that market will again rebound. People have even invested their hard-earned money in stocks of such companies, which do not have the strength to sustain in the market for the long term. Their financials are not so good and they have no track records. Some companies are such that they have manipulated their financials with help of professionals for those books looks impressive and sound.

Investment in stock market needs sound financial knowledge , information, consistency and discipline. There are many Social Media Influencers providing investment advice to these innocent retail investors and their advice cost a lot to these investors.

Right now we cannot change the fate and conditions of the market unless Government takes some action to remove or decrease tax on Capital Gains. There is not need to increase Short Term/Long Term Capital Gains in the recent budget /earlier budget.

The figures of GDP in recent quarters are also not impressive and there are decline in manufacturing, production, services and other field also ,which fuels downtrend in Stock Market.

There is no money remaining in the hands of the public to purchase products and utilise services and hence stocks of FMCG and other companies also fall. One more thing is this government has brought culture of Tax Terrorism; on every product you are using you have to pay tax and tax department authorities are threating people and businesses for levying and recovery of taxes.

LEAVE THE ABOVE DISCUSSION, LET'S DISCUSS HOW YOU CAN UTILISE CURRENT LOSSES IN THE STOCK MARKET TO SAVE TAXES

First, let's understand what Tax Harvesting is

Tax harvesting involves strategically selling investments at a loss to offset capital gains and reduce tax liability. By realising losses, investors can decrease their taxable income, potentially saving money on taxes. This technique is commonly used to optimise investment portfolios.

Tax harvesting is a strategy used by investors to maximise tax benefits, particularly concerning long-term capital gains (LTCG). Before 2018, there was no tax imposed on LTCG. However, when the government introduced this tax, they provided a small benefit: capital gains up to Rs 1.25 lakh are tax-free in case of equities.

It means that if you have various stocks in your portfolio for leveraging , it may be possible that some stocks and performing well and some stocks are not. There may be loss in some stocks and gain in other stocks. In case of gain , it can be Long Term or Short Term Capital Gain ,depends the period of holding these stocks.

• Long Term Capital Gain: if a person holds stocks more than 12 months in case of listed or 24 months in case of unlisted stocks.
• Short Term Capital Gain: if a person holds stocks less than 12 months in case of listed or 24 months in case of unlisted stocks.

PLEASE NOTE THAT: Beginning from 1 April 2018, an LTCG of more than Rs 1 lakh will be taxed at the rate of 10% without the benefit of indexation. Compared to that, short-term capital gains (STCG) are taxed at a rate of 15%. In this case, you can employ tax-loss harvesting to reduce the tax liability on both LTCG and STCG. Usually, investors use it for STCG because the tax rates on short-term capital gains are higher than that of long-term capital gains.

After Budget 2024-25

• Long Term Capital Gain: will be taxed @12.5% without indexation on or above Rs. 1.25 Lakhs ;and
• Short Term Capital Gain: will be taxed @20% according to your slab rate.

PLEASE NOTE THAT: Tax Loss Harvesting is not a year-end process , it is a planned exercise during the financial year. Tax-loss harvesting starts with the sale of the stock or an equity fund which is experiencing a consistent price decline. You feel that the security has lost most of its value and chances of a rebound are bleak. Once the loss is realised, you offset it against capital gains that your portfolio has earned over the period.

Let's consider an example: Shubham has been holding onto his stocks for three years, and his long-term capital gain amounts to ₹3 lakhs. Deducting the ₹1.25 lakh exemption, he is left with ₹1.75 lakhs, on which he would have to pay a 12.5% tax, amounting to ₹21,875.

On the other hand, suppose another investor, let's call him Varun, adopts the tax harvesting strategy. Varun sells a portion of his profit-making shares every year, realising his LTCG annually. By doing so, Varun effectively resets the cost basis of his investments each year, ensuring that his gains remain within the ₹1.25 lakh exemption limit. Therefore, even after three years, when Varun's total LTCG amounts to ₹3 lakhs, he owes no tax because he has systematically realised and reinvested his gains each year.

THE INCOME TAX ACT PROVIDES TWO IMPORTANT CONCEPTS

1. SET OFF: Set off allows taxpayers to offset their losses against any profits they may have made in the same financial year. For instance, if Varun had any business or capital gains during the year, he could set off his losses against those gains, effectively reducing his taxable income. There are specific rules regarding which types of losses can be set off against which types of gains, such as long-term capital losses can only be set off against long-term capital gains, and so on.

PLEASE NOTE THAT: Income Tax does not allow setoff of Capital Losses against any other income.

1. Long Term Capital Loss can only be set off against Long Term Capital Gain;

2. Short Term Capital Loss can be set off against both long-term capital gain /short-term capital gain.

2. CARRY FORWARD: In cases where taxpayers have losses but no profits to set them off against, the Income Tax Act allows for the carry forward of losses. This means that Varun can carry forward his ₹1.25 lakh loss for up to eight years. If he earns profits in any of the subsequent years, he can offset those profits with the carried forward loss, thereby reducing his tax liability in those years.

PLEASE NOTE THAT: the crucial point that Varun missed: In order to avail of the benefit of carry forward, it is imperative to file an income tax return. If Varun chooses not to file a return, he forfeits the opportunity to carry forward his losses, potentially missing out on significant tax benefits in the future.

Therefore, while incurring losses may seem discouraging, it's essential to understand the provisions of set off and carry forward provided by the Income Tax Act. By filing an income tax return and utilising these provisions effectively, taxpayers like Varun can minimise their tax burden and make the most of their investments in the long run.

Let's understand with an example

During the FY 2023-24, Mr Shyam has the following income and brought forward losses:

What is the capital gain taxable in the hands of Mr. Chetan for the AY 2024-25?

Solution:

PLEASE NOTE: Long-term capital loss cannot be set off against short-term capital gain. Hence, the unadjusted long-term capital loss of AY 2022-23 of Rs 11,000 (i.e., Rs. 96,000 - Rs. 85,000) has to be carried forward to the next year to be set off against long-term capital gains of that year.

Let's consider another example

Suppose Mr. X's Portfolio has gained Rs. 5,00,000/- as long-term capital gain during FY 2024-25 and he also has Rs. 2,50,000/- Short Term Capital Loss in FY 2024-25.

Case 1: Now in this case Tax Calculation is as follows;

• Long Term Capital Gain: Rs. 5,00,000
• Less: Short Term Capital Gain Rs. 2,50,000

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Net Capital Gain (LTCG) Rs. 2,50,000

Less: Exemption Rs. 1,25000

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Net Capital Tax Rs. 1,25000/-

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Tax on LTCG Rs. 1,25000*12.5%=Rs. 15,625

Suppose Mr. X's Portfolio has gained Rs. 5,00,000/- as long-term capital gain during FY 2024-25 and he also has Rs. 7,50,000/- Short Term Capital Loss in FY 2024-25.

Case 1: Now in this case Tax Calculation is as follows;

• Long Term Capital Gain: Rs. 5,00,000
• Less: Short Term Capital Gain Rs. 7,50,000

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Net Capital Gain (STCG) Rs. (2,50,000)

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This STCL will be carried forward for a period of 8 years and set off against both LTCG and STCG. If there is loss of LTCG then it can be setoff against only against LTCG.

CONCLUSION

Don't panic, you cannot change destiny, if you have suffered loss in stock market , then diversified your portfolio and include Debt Instruments, GOLD, ETFs etc. and most important built an Emergency Fund. Do not take loan and invest in the market because all days will not be shiny days. Investment is a process which involves information, knowledge, discipline , commitment and understanding of financials of companies.

DISCLAIMER: The article presented here is only for sharing information with readers. The views expressed ere are personal views of the author, do not consider it professional advice. In case of necessity consult with professionals.