Tax-Loss Harvesting in Equity Investments

This article talks about the tax-loss harvesting strategy, which is a fundamental strategy for reducing tax liability and increasing post-tax returns.

Tax is something that is charged on almost anything you do or purchase, directly or indirectly. Even when you make profits on your investment portfolio, tax is levied. Though it is next to impossible to escape taxation, you may save a certain portion of your tax through several tax-saving strategies. One such strategy which is increasingly used in the share market is Tax-loss harvesting. Nobody likes seeing the value of assets in their investment portfolio fall, but what if you can use the assets that have lost their value to increase your overall post-tax returns. Through tax-loss harvesting, you can take advantage of the falling value of your asset in the portfolio. Let us look at what is tax-loss harvesting and try to understand how it works.

What is Tax-Loss Harvesting?

Tax-loss harvesting is a fundamental strategy for reducing your tax liability and increasing your post-tax returns. This strategy is specifically beneficial for investors and traders for reducing their tax outgo on realized capital gains before the closure of the financial year through booking sell orders on loss-making stocks. Through these sell orders, you can book losses, which can be used to offset the gains in any other instruments, thus bringing down your total taxable income and subsequently tax liability. In India, the Income Tax Department permits taxpayers to set off their capital losses against capital gains in order to reduce their tax liability. Although most investors use this strategy for harvesting their capital losses towards the end of the financial year, you can also use it as a regular process for maintaining your capital gains at a low level throughout the financial year. The basic objective of this strategy is reducing the amount payable as tax by offsetting capital loss on underperforming assets from the capital gains from other sources. While planning your tax-loss harvesting, it is significant to note the following rule of setting off as per the IT Act, 1961:

  • The long-term capital losses can be set off only against long-term capital gains and not against short-term capital gains.
  • The short-term capital losses can be set off against both short-term capital gains and long-term capital gains.

How does Tax-Loss Harvesting work?

The process of tax-loss harvesting is simple. You need to follow the following steps:

  • Firstly, you need to decide regarding the timing of your tax-loss harvesting. Most of the investors prefer using this strategy only at the end of the financial year while filing their returns. But instead, you may also use it throughout the year in a pre-planned manner to keep your capital gain at a low level.
  • After deciding upon the timing, you need to identify the assets in your portfolio with continuously falling prices. You must choose only those financial assets which, on the day of sale, are giving you negative returns i.e., capital losses. You should choose assets you feel have lost most of their value and the chance of a rebound is very bleak.
  • Once you have identified these assets, you need to start with the sale of these stock or equity funds.
  • The loss realized from the sale of these assets is finally utilized to set off the capital gains from other sources, thereby reducing your overall tax liability.
  • At the end of tax-loss harvesting, you can buy other attractive stocks or equity funds from the amount realized from the sale of the loss-making financial instrument. This kind of replacement becomes important for maintaining the original asset allocation of your investment portfolio. You may also repurchase the same stock after a few days.

What are the benefits of Tax-Loss Harvesting in India?

Tax-loss harvesting is widely considered a critical strategy to save tax by many investors. In India, tax-loss harvesting offers the following benefits to investors:

  • Absence of Wash Sale Rule in India: Tax-loss harvesting is highly profitable in India due to the absence of any wash sale rule in the country. Wash sale refers to the process of selling a security at loss and then repurchasing it or another substantially identical security shortly before or after the sale order. Originally, wash sale is an American regulation that applies to the US stock market. Under this rule, no investors can use the losses from sales for setting off the capital gains and reducing their tax liability. Indian investors need not worry about this regulation as there is no such provision in India.
  • Reduction of Tax Liability: Investors can reduce their tax liability by using a tax-loss harvesting strategy in the manner explained above. By selling their loss-making securities, which are giving either a short-term or long-term capital loss, they can effectively reduce their tax costs.
  • Reorganization of Portfolio: Through the tax-loss harvesting strategy, investors can also reorganize their investment portfolios. The reorganization of the portfolio helps the investor in improving the balance between the returns, risk, and their overall wealth.

What are the downsides of Tax-Loss Harvesting?

Although many investors use tax-loss harvesting to reduce the tax payments on their hard-earned money, this strategy may not be beneficial for all such investors. One of the primary drawbacks of this strategy is that not all assets currently running at a loss is a bad investment. If a loss-making stock offers you good diversification benefits and balance your long-term returns, it may not be a good idea to sell such stock. Thus, this strategy might result in the loss of value stocks, which you may not be able to repurchase at the same price. Additionally, this strategy requires experience and knowledge about the market, and thus it can accrue additional losses if performed without the assistance of an expert or any financial advisor.

Summary

Tax-loss harvesting is a simple yet effective way to keep taxes low on equity investments. However, while performing this strategy, you need to be extra careful in examining your overall returns, as a careless strategy can lead to a net loss in the name of reducing your tax payments. In India, the financial markets and government offer investors a fair chance to save their taxes legally through the process of tax-loss harvesting. You should always use this strategy in accordance with your goal, risk tolerance, financial knowledge, and a thorough understanding of the complete process.

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