Tax Loss harvesting is basically a sell-off of securities that are in red to offset the payable capital gains tax.
As an investor, likely, you will at least get that one lousy performing stock for ten great investments. And it’s fair; you can’t always make the best investment choices and only have your stocks grow multiple times without these bumps on your way.
But when things like this happen, and you see your assets in red, it’s an opportunity for you to save on tax.
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How Does Tax Loss Harvesting Work?
When you invest in equity markets, your assets can either make capital gains or incur capital losses.
Capital gains from your investments are taxed as short term capital gains (15%) and long-term capital gains (10%). But what about when you incur a loss? If you incur a capital loss, you can use it to lower the amount you pay in taxes on capital gains.
Let’s say you have an underperforming asset, and there is no hope for it to get back on track and cover the losses. What you can do is sell it off and deduct the loss amount from your portfolio and then pay capital gains tax. This way, because you have incurred a loss, your net capital gains will become lower, and you will be taxed on a lower amount.
But if you don’t do this and continue to hold the red asset, you will pay more taxes.
Let’s say you have a portfolio with a total capital gain of ₹1,00,000 in one financial year.
Short term capital gains – ₹ 40,000
Long term capital gains – ₹ 60,000
So you will be taxed as follows:
STGC = 40000 X 15% = ₹ 6000
LTGC = 60000 X 10% = ₹ 6000
Your total tax liability will be ₹ 12,000
This would be in case of no capital losses in your portfolio. However, there is a good chance that you may have some capital losses in your profile. If you notice any such stocks that have reached their lower levels and don’t see a potential in them to bounce back, you can sell those stocks and realise a capital loss.
Capital loss = The value of the asset at the time of purchase – current value.
Let’s say you have noticed a short term capital loss of ₹ 10,000 in your portfolio; you can realise the loss and reduce your tax liability.
Here’s the working for it:
STGC = (40000 – 10000) X 15% = ₹ 4500
LTGC = 60000 X 10% = ₹ 6000
Your total tax liability will be ₹ 10,500
In the two calculations we did, in the first one, because there was either no capital loss or you did not realise capital losses, you ended up paying more in taxes than in case you realised capital losses.
Things to Know Before You Do Tax-Loss Harvesting
Tax Loss harvesting is a great way to save on taxes, but while doing so, there are a couple of things you should be aware of:
1. Wash Sale Rule
According to the Wash Sale rule, you cannot sell a security and realise capital losses against it if you have bought similar security immediately before or after its sale. If you are found doing this, then the tax concession you gained will be reversed.
Hence you should only sell assets that you believe can’t bounce back. However, you can purchase similar security later in the future.
2. Admin Cost
The process of Tax-loss harvesting might attract some administrative fee if you are not doing your own taxes or need some outside help. Additionally, the sale of security may also attract some fees.
Hence, it’s best to consider the admin cost you will before opting for tax-loss harvesting. If the benefit you are receiving is more than the admin cost you will incur, you may want to go ahead.
It also means that it isn’t feasible to sell smaller portions of your portfolio frequently. Because the more regularly you write off securities, the more fees you will incur. Instead, create a batch and do it timely.
3.LTCL = LTCG, STCL = STCG or LTCG
While setting off losses, you should always know that:
Long term capital losses (LTCL) can only be set off against Long term capital gains. In contrast, You can offset Short term capital losses against both Short term and long term capital gains.
To sum it up: you should be actively monitoring your portfolio and reviewing each stock’s performance; while there must be some high performing asset’s in it, there might be some stocks that you may want to get rid of and get tax benefits in exchange.
KuberVerse is an educational initiative. Anything expressed here directly or indirectly is not investment advice. And we ask you to do your own research before investing.