When you redeem your mutual funds after holding them for a period longer than 12 months, long-term capital gains (LTCG) tax is payable on them. When the redemption takes place in less than 12 months, short-term capital gains (STCG) tax is payable on it.
Most investors only sell a portion of their portfolio, and these include some of the units they acquired at different price points over a period of time. Therefore, how can one determine when the units that are being sold today were indeed acquired?
The short answer to the above question is FIFO, i.e., First In First Out. In other words, the units that are purchased first are believed to be sold first.
Why is FIFO relevant?
The FIFO method, which is common among the sale of shares as well as mutual fund units, is a routine method to determine the holding period of units as well as to calculate the profit earned on the sale.
Let us suppose you bought some units two years ago and the remaining units only two months ago. When you sell a portion of those units, it would suit you to call the sold units the same ones which you bought recently to avoid paying more taxes.
To avoid this sort of confusion, it is a common practice that the units bought first are sold first. This helps compute two things: a) the holding period of assets (based on which it can be ascertained whether it is a short-term or long-term capital gain). b) cost of acquisition, which is important to calculate capital gains.
Price and value differ
One key consideration that needs to be factored in while applying the FIFO method is that the number of units is considered separately from the amount at which they are bought. For example, Mr X buys 100 units for ₹10,000 via SIP in a month. The following month, he buys 90 units for ₹10,000 via the SIP of the same amount.
If he sells 180 units after two years for ₹40,000, then the capital gains will be computed based on the assumption that he sold all the units that he acquired in the first month and only 80 units he acquired in the second month.
The calculation appears simple, but the confusion arises when the investor continues to acquire more units during these two years at different price points.
However, the FIFO method removes this confusion and brings order to the calculation.
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