Capital gains refer to the profit an investor earns when selling an asset. So, for example, when you exit a mutual fund at a higher price than you originally paid for it, you will be said to have capital gains. Capital gains are a key reason why people invest in mutual funds. But with gains come taxes. This article helps you understand how to calculate one type of tax—the Long-Term Capital Gains (LTCG) tax on mutual funds.
What are capital gains?
Understanding capital gains is paramount for any mutual fund investor because it can affect their overall return on investment. When they sell their mutual fund shares, they may incur a capital gain or loss depending on how much the share price has changed.
In the context of mutual funds, capital gains can be divided into two categories: equity mutual funds and debt mutual funds.
Capital gains for equity mutual funds
For equity mutual funds, capital gains occur when the fund manager sells stock in the fund portfolio for a profit. When this happens, the fund distributes the gains to the investors responsible for paying the tax on them.
In general, equity mutual funds have a higher potential for capital gains (and losses) than debt mutual funds. This is due to their exposure to the stock market.
Capital gains for debt mutual funds
For debt mutual funds, capital gains occur when the fund manager sells a bond or other fixed-income security in the fund portfolio for a profit. Like equity mutual funds, the fund may distribute the capital gains to its investors, who are responsible for paying taxes.
Types of capital assets on mutual funds
There are three main types of capital assets that mutual funds invest in: equity, fixed income, and alternative assets. It’s important to note that not all mutual funds invest in all three types of assets. Some focus exclusively on one type of asset, while others invest in a combination. The type of assets will depend on the fund’s investment objectives and strategy as well as the risk tolerance of the investors.
Long-term capital gains taxation on the sale of mutual funds
In India, Long-Term Capital Gains (LTCG) on the sale of equity mutual funds are taxed at 10% if the gains exceed ₹1 lakh. On the other hand, the sale of debt mutual funds attracts a tax rate of 20% with indexation benefits.
For perspective, the investor’s marginal tax rate applies to short-term capital gains (STCG) on the sale of equity and debt mutual funds.
Exemptions on capital gains
In India, there are certain exemptions available for capital gains. For example, suppose the proceeds from the sale of a residential property are reinvested in another residential property within a specified time frame. In that case, the capital gains from the sale of the first property are exempt from tax. Similarly, there are exemptions for gains from the sale of specified assets. Government securities, equity shares, and units of equity-oriented mutual funds receive such exemptions.
The exemptions and their eligibility criteria vary on the basis of the type of asset and the holding period.
How to calculate the long-term capital gains tax payable on mutual funds
The long-term capital gains tax on mutual fund investments arises on sale after 12 months. To calculate the LTCG, the key is to adjust the cost of acquisition for inflation using the Cost Inflation Index (CII). Then subtract the indexed acquisition cost from the fund units’ sale price.
The calculation of long-term capital gains tax
Suppose you purchase 1,000 units of an equity-oriented mutual fund on 1 January 2018 at the cost of ₹10 per unit. Now assume you sell the units on 2 January 2022 for ₹15 per unit. The applicable CII for the year of purchase is 272, and for the year of the sale, it is 317.
As you hold the mutual fund units for more than 1 year (i.e., for 4 years), the gains from selling these units are LTCG.
Then compute the indexed cost of acquisition using the following formula:
Indexed cost of acquisition = Cost of acquisition x (CII for the year of sale / CII for the year of purchase)
In this case, the acquisition cost is ₹10 per unit, and the CII for the year of purchase is 272. Meanwhile, the CII for the year of sale is 317. Therefore, the indexed cost of acquisition per unit is: 10 x (317/272) = ₹11.60
To calculate the LTCG now, subtract this indexed acquisition cost from the sale price per unit. Then multiply it by the total number of units sold. In this case, the LTCG will be:
LTCG = (15 – 11.60) x 1,000 = ₹3,400
As it is an equity-oriented mutual fund, LTCG tax at the rate of 10% applies if the gains exceed ₹1 lakh. As the LTCG, in this case, is ₹3,400, the tax payable will be 10% of ₹2,400 (i.e., ₹240).
What is an indexed cost of acquisition?
The indexed cost of acquisition is a method used to adjust the purchase price of a capital asset to account for inflation over time. In India, it is particularly relevant to compute capital gains tax on LTCG from selling assets like mutual funds or stocks.
The cost of acquisition is the asset’s original purchase price, and the indexed cost of acquisition is this original cost adjusted for inflation using the Cost Inflation Index (CII) that the government issues each year. The indexed cost of acquisition is computed using the following formula:
Indexed Cost of Acquisition = Cost of Acquisition x (CII of the year of sale / CII of the year of purchase)
Each year, long-term capital gains on equity mutual funds are tax-free up to ₹1 lakh, so ensuring that long-term investments benefit from this tax exemption makes sense. If you plan to sell mutual fund units after holding them for over 3 years, consider taking advantage of the indexation benefit to reduce your tax liability.
A major grouse with investors is that the frequent buying and selling mutual fund units can attract short-term capital gains tax, which is higher than LTCG tax.
Do I need to pay mutual fund taxes on a yearly basis?
Whether you pay mutual fund taxes annually depends on where you hold them and the income it accrues in any year. Generally, shares in a taxable account are liable to an annual tax.
Do mutual fund investments incur wealth taxes?
There is currently no provision for a wealth tax on mutual fund investments. However, dividends earned annually may attract tax deduction at source.
Are LTCGs on a mutual fund taxable?
Long-term capital gains of up to ₹1 lakh are tax-free. A tax rate of 10% applies to the rest when it’s equity funds and 20% for debt.
How does one reduce capital gain tax through tax harvesting?
Tax harvesting refers to the concept of declaring a loss by selling underperforming stocks and using that to offset the taxes one would have to pay that year. The offsetting reduces the taxable amount in capital gains.
What is an example of a long term capital gain?
An example of long-term capital gain is when an individual buys stocks and holds them for more than one year before selling, resulting in a profit. The profit is then subject to favorable long-term capital gains tax rates.
What is long term capital gains tax at 20%?
The long-term capital gains tax at 20% applies to certain assets, such as stocks and real estate, held for more than one year. This rate is typically lower than the short-term capital gains tax rate.
What is the rule for long term capital gain?
The rule for long-term capital gains typically involves holding an asset, like stocks or real estate, for more than one year before selling. The tax rate is often lower than that for short-term gains.
How do you calculate long term capital gains on 112a?
To calculate long-term capital gains on Form 112A in India, subtract the cost of acquisition and improvement from the selling price. Apply indexation if holding exceeds two years. The formula is : Capital Gain
= (Selling Price − Indexed Cost of Acquisition) − Exemptions Capital Gain=(Selling Price−Indexed Cost of Acquisition) − Exemptions.