Tax loss harvesting is an approach that enables investors to cut down on taxes while managing their investments. The strategy involves selling assets that are at a loss. They are offset against the gains from other investments, reducing the amount of taxable income.
This strategy not only helps reduce tax exposure but is also a good opportunity to achieve portfolio rebalancing and even improve returns on a broader level. In this article, we will focus on understanding how tax loss harvesting can enhance the overall investment strategy.
What is Tax Loss Harvesting?
When you invest in equity funds, any capital gains you earn are subject to taxes depending on your holding period. Tax-loss harvesting can help minimise your tax burden by offsetting gains with losses.
So basically, tax loss harvesting is an investment strategy that involves selling assets at a loss to offset taxable gains or reduce taxable income, thereby minimising overall tax liability. These realised losses can then be used to offset taxable capital gains, reducing the investor's overall tax liability for the period.
By reinvesting the proceeds into similar, but not identical, assets, the investor maintains market exposure while optimising their portfolio’s tax efficiency.
It also supports portfolio rebalancing, allowing you to align your investments with your financial goals without significant tax burdens.
In order to comprehend tax loss harvesting entirely, it is necessary to comprehend the distinction between realised and unrealized losses.
Realised: A loss is realised only when you decide to sell the investment. Such a loss can be claimed for tax reduction purposes.
Unrealized: On the other hand, unrealized losses are paper losses on investments you still hold and cannot be used to offset gains.
Realised losses can offset capital gains, which come in two types: short-term (from investments held for less than a year, taxed at higher rates) and long-term (from investments held for over a year, taxed at lower rates). Offsetting gains with losses helps minimise the taxes owed, especially on high-tax short-term gains.
How Does Tax Loss Harvesting Work in India?
Tax loss harvesting in India operates under the rules and provisions of the Income Tax Act, 1961, which governs the treatment of capital gains and losses.
Under the Act, capital gains and losses are classified as short-term (held for less than 12 months for equity or less than 36 months for most other assets) or long-term (held for longer). Losses can only be used to offset gains of the same type.
Short-term capital losses can be used to offset both short and long-term capital gains.
Long-term capital losses can only offset long-term gains.
If losses cannot be fully utilised in the same financial year, the law permits their carry-forward for up to eight years, provided the taxpayer files their returns on time. This principle applies across different asset classes.
For equity investments like stocks and equity mutual funds, short-term gains are taxed at 20%, while long-term gains exceeding ₹1.25 lakh in a financial year are taxed at 12.50%. Selling a losing equity investment can help offset gains from another, reducing your tax bill.
Similarly, debt investments like bonds and debt mutual funds, which have different tax treatments, can also be used for tax loss harvesting. Losses from these assets follow the same offset and carry-forward rules.
Even real estate and other asset classes, such as gold, follow this framework. For example, if you sell a property at a profit but incur a loss in another investment, you can use the loss to offset the gain, lowering your taxable income.
In all cases, planning is necessary to maximise the benefits of tax loss harvesting. Aligning your portfolio management with these rules, you can save taxes while staying invested and compliant with Indian tax laws.
Strategies for Tax Loss Harvesting: How You Can Offset Gains?
Now that we understand what tax loss harvesting is and how it works, let’s jump into some practical strategies you can use to make the most of this powerful tax-saving tool and keep more of your money working for you.
1. Regular Portfolio Review
As a way to seek chances for tax loss harvesting, check your investment portfolio from time to time. This assists in identifying assets that have lost value and could be offloaded to cancel out gains from other assets.
A systematic procedure helps you avoid missing the harvesting chances timelines that are not so favourable.
2. Tracking Cost Basis and Current Market Value
Understanding the cost basis (the price you pay for a given asset) and its comparison to the current market value is essential. This assists in the determination of losses upon the sale of an asset.
Keeping thorough records allows you to make educated choices as to which assets should be disposed of in order to achieve maximum tax relief.
3. Year-End Tax Planning
Time to circle back to your portfolio as year-end is a wonderful time for some tax loss harvesting.
As the financial year comes to a close, consider your realised gains and look for areas where losses can be harvested. This way, you are also able to take care of any tax-saving measures well in advance.
4. Balancing Tax Benefits with Investment Goals
It’s important to save on taxes, but it should never compromise your investment goals for the long term. Make sure that tax loss harvesting fits within this strategy and does not undermine diversification and future growth potential.
Invest in the same category of assets, though not exactly the same, to keep your portfolio balanced.
Conclusion
Tax loss harvesting is a valuable tool for reducing taxes and improving investment returns. Selling underperforming assets to offset gains allows you to keep more of your money working for you.
No matter if you manage your portfolio yourself or seek professional help, it's important to follow the rules and make sure this strategy aligns with your financial goals.
