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To harvest something means to pick or collect it. You could do the same in investing: Tax-loss harvesting is the selling of stock/mutual funds at a loss to offset a capital gains tax liability, and normally such investments are bought back to maintain the same asset allocation/portfolio.

When one earns profits on sale of capital assets, it is taxed as long-term capital gains (LTCG) or short-term capital gains (STCG) based on the holding period. The tax on such profits can be cut down to some extent using a sophisticated tax planning mechanism known as tax-loss harvesting.

Say, you invested 6 lakh in listed shares and 3 lakh in equity-oriented mutual funds in April 2018. The value of the shares is 4.5 lakh in April 2020 and the value of the mutual funds is 5 lakh. You want to liquidate the mutual funds. The LTCG on redemption of MF is 2 lakh (sale value of 5 lakh - cost of 3 lakh). Of this, 1 lakh is exempt and you pay 10% plus cess of 4% as LTCG tax i.e. 10,400.

Prior to 31 March 2018, there was no tax on LTCG on shares and equity-oriented mutual funds; therefore, long-term loss on such transactions was considered as a dead loss. After 31 March 2018, the scenario changed; profits/gains on long-term shares or equity-oriented mutual funds are now taxable in excess of 1 lakh.

Every coin has two sides. The positive side to this tax provision is that if you have incurred a long-term capital loss on sale of shares or equity-oriented mutual fund units, then you can set them off against any LTCG.

So, in the above example, even though you want to keep holding the shares for the long term, for the purpose of tax planning you sell the shares and reinvest the sale proceeds in the same shares within the next two to three days. This sale and reinvestment is a legal transaction and does not affect your investment amount or returns generated. The 1.5 lakh long-term capital loss (LTCL) on sale of shares can be set off against the LTCG of 2 lakh on redemption of the MF and the balance LTCG of 50,000 being less that 1 lakh is exempted. Thus, you pay no tax.

Also, in case losses from the sale of capital assets exceed the gains from such assets after setting off losses and gains of a particular year, you can carry forward such losses for setting off in later years up to eight assessment years. However, keep in mind that losses for a year cannot be carried forward unless that year’s return has been filed before the due date.

It is pertinent to note that LTCG can be set off against LTCL and short-term capital loss (STCL), whereas STCG can be set off only against STCL. There is no asset class restriction on the set off. Hence, losses in equities can be set off against gains in debt, real estate or gold.

Case study: Let us consider the case of Rakesh, for instance. During the year, Rakesh sold a plot of land he had purchased for 1 lakh in April 2001 for a price of 5 lakh. The cost of acquisition after indexation benefit is 3.17 lakh. The LTCG on this sale after benefit of indexation is 1.83 lakh. What action can Rakesh take to reduce his tax liability in this case? Also, eight months ago, he had purchased 1,500 listed shares in Company A at 200 per share. The share is now trading at 20 each. Is any action required for these shares?

Since Rakesh has sold the land he has held for more than 24 months, the sale is liable to LTCG tax. The tax on LTCG of 1.83 lakh will be 38,064 (20% LTCG tax plus 4% cess).

Suppose Rakesh does not want to buy a house or invest this amount in capital gains bonds of the government, he can save tax by selling off the 1,017 shares of Company A and booking loss of 183,060 (sale value of 20,340 - cost of 203,400), which can be set off against LTCG of 1.83 lakh. Thus, the tax liability will be nil. Rakesh can carry forward STCL of 60 and set it off against capital gains in the next eight years.

Also, if Rakesh wants to continue his holdings in Company A, he must reinvest the sale proceeds of 20,340 in Company A’s shares within the next two to three days. Thus, he will continue his investment holdings and also save on tax.

Nitesh Buddahdev is the founder of Nimit Consultancy.

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