Investing in equity mutual funds can yield substantial returns over time, but it also comes with tax obligations. Long-term capital gains (LTCG) from equity mutual funds are taxed if they exceed a certain threshold in a financial year. However, investors can use short-term capital losses (STCL) to offset taxable gains and reduce their tax burden effectively. Understanding how this works can help investors optimise their tax liabilities and maximise post-tax returns.
Understanding Long-Term and Short-Term Capital Gains and Losses
Long-term capital gains arise from selling equity mutual funds held for over a year, while short-term gains apply to those sold within a year. Similarly, long-term and short-term capital losses occur based on the holding period.
As per current tax laws, long-term capital gains exceeding ₹1.25 lakh in a financial year are taxed at 12.5%. On the other hand, short-term capital gains are taxed at a flat 15%.
How Short-Term Losses Reduce LTCG Tax Liability
If an investor incurs a short-term capital loss from the sale of equity mutual funds, they can use it to offset their taxable long-term capital gains, reducing the overall tax payable. This tax-saving strategy is known as tax-loss harvesting.
Example of Tax Reduction
Suppose an investor earns ₹2 lakh in long-term capital gains from equity mutual funds in a financial year. The first ₹1.25 lakh is exempt from tax, leaving ₹75,000 taxable at 12.5%, which results in a tax liability of ₹9,375.
Now, let’s assume the same investor also incurs a ₹50,000 short-term capital loss from another equity mutual fund. By offsetting this loss against the taxable LTCG, the new taxable amount becomes ₹25,000 instead of ₹75,000. Consequently, the tax liability drops to ₹3,125 instead of ₹9,375—offering a significant tax saving of ₹6,250.
Rules for Offsetting Capital Gains with Capital Losses
- Short-term capital losses can be used to offset both short-term and long-term capital gains.
- Long-term capital losses can only be used to offset long-term capital gains.
- If the total capital losses exceed the gains in a year, the remaining loss can be carried forward for up to 8 assessment years and adjusted against future gains.
Carrying Forward Short-Term Capital Losses
If an investor’s short-term capital loss exceeds their total capital gains in a financial year, they can carry forward the remaining loss for up to 8 years. However, to claim this benefit, the investor must file their income tax return (ITR) within the due date and report the capital losses appropriately.
Things to Keep in Mind
- Maintain proper documentation: Keep records of all investment transactions, including purchase and sale details, to substantiate capital gains and losses during tax filing.
- File ITR on time: Losses can only be carried forward if they are reported in the ITR filed before the due date.
- Review investment goals: Avoid selling profitable investments solely for tax benefits. Consider long-term growth potential before making decisions.
- Understand tax laws: Tax rates and exemptions may change, so staying updated on the latest rules is essential.
Conclusion
Short-term capital losses can be a valuable tool in reducing long-term capital gains tax. By understanding how to offset taxable LTCG with STCL, investors can significantly cut down on tax liabilities and improve their overall investment returns. Proper planning, timely tax filing, and awareness of offsetting rules can help investors make the most of tax-saving opportunities while maintaining a robust investment strategy.
Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. This does not constitute a personal recommendation/investment advice. It does not aim to influence any individual or entity to make investment decisions. Recipients should conduct their own research and assessments to form an independent opinion about investment decisions.
Investments in the securities market are subject to market risks, read all the related documents carefully before investing.