Have underperforming stocks in your portfolio? What if there was a way to move loss-making securities in favour of reducing tax liabilities? Here’s how you can do it with the tax loss harvesting strategy.
What is tax-loss harvesting?
Tax-loss harvesting as a strategy to reduce tax liabilities has become more relevant in the light of changes in the tax laws. Before 2018, long term capital gains made on the sale of stocks or equity funds were not taxable. But since April 2018, they are taxable at 10 percent over and above Rs.1 lakh, which is without indexation. In the context of equity shares of companies, securities listed on recognised Indian stock exchanges, and equity-oriented funds, short term capital gains, that is, capital gains made on the sale of assets held for less than a year is taxed at 15 percent.
Tax-loss harvesting strategy involves selling off loss-making stocks in your portfolio. You can realise the losses and adjust them against capital gains and in doing so, reduce your tax liability and improve post-tax returns on your portfolio. With the realised sum, you can buy a stock from a similar sector to maintain the overall valuation of the fund.
How does tax-Loss harvesting work?
Here are the broad steps involved in tax loss harvesting
- Spot the assets in your portfolio that have continuously been underperforming, and where chances of price reversal are slim.
- Sell these stocks and realise the losses.
- These losses can be offset against the overall capital gains made from the portfolio.
- This will reduce your taxable capital gains.
While adjusting losses against capital gains, do remember that you can only adjust long term capital losses against long term capital gains. Moreover, you can adjust short term capital losses against both long term and short term capital gains.
While setting off losses using tax loss harvesting, you need to keep the following points in mind:
- Long term capital losses can be set-off against only long-term capital gains. You cannot set-off long-term capital losses against short-term capital gains.
- Short-term capital losses can be set-off against either short-term capital gains or long-term capital gains.
Let us see with an example, how this works:
To understand the impact of the strategy better, let us see two scenarios-one without using the strategy and one after tax loss harvesting.
For example, in your portfolio, you have four stocks of company A, B, C and D that you bought at Rs. 400, Rs. 800, Rs. 1200 and Rs. 500 respectively on January 2nd, with a total principal capital investment of Rs. 2900.
Stock A- Rs. 400
Stock b- Rs. 800
Stock C- Rs. 1200
Stock D- Rs.500
On March 20th, you find that the stock price of company A has consistently declined, while prices of other stocks have gone up. The stock prices currently are at
Stock A- Rs. 150
Stock B- Rs. 900
Stock C- Rs. 1300
Stock D- Rs.700
Now at this point, you can sell off stock A, book the losses. With the proceeds, you can do two things: after two days, you can buy more shares of company A (investors may usually do this to keep their exposure to the sector unchanged). Second, you can purchase shares of a company with a similar coefficient of correlation. Or if you think the price bleeding is likely to stop, you can choose to hold on to the stock.
We will consider how tax loss harvesting affects both the scenarios, where you book the losses and where you don’t.
For ease of calculations let us assume, you did not sell stock A. by the end of the financial year, you found the stock prices stood at
Stock A- Rs.600,
Stock B- Rs.1,000,
Stock C- Rs. 1400
Stock D- Rs. 900
Now your net profits or short term capital gains or STCG at the end of the year stand at Rs. 200+Rs.200+Rs.200+Rs.400=Rs.1000.
But how does loss tax harvesting play out in terms of reducing your taxable income?
Without employing a tax-loss harvesting strategy:
By broad estimates, in a case, where you did not book losses, your tax liability would be 15 percent of STCG, that is Rs. 150. Your post-tax profit will be Rs. 850.
After employing a tax-loss harvesting strategy:
You sold off stock A and booked a capital loss of Rs.350 on March 20th. Now, adjusting your capital gains for the losses, your net short term capital gains at the end of the year stand at Rs.650. Your tax liability on short term capital gains will be 15 percent of Rs.650, that is Rs.97.5. Your post-tax profit will be Rs. 552.5. You will see that tax loss harvesting manages to bridge the gap between the tax outgo in the two scenarios.
Now this above is just a straightforward example with minimal hypothetical sums that we have discussed here for ease of understanding. But in the real investing world, this tax-saving strategy can save you a lot more, and help you rationalise your capital gains at the end of the year or throughout the year. Tax-loss harvesting enables you to shore up your gains, save you on your taxes by merely setting off capital losses against profits you make on your portfolio.