Investing in the equity market can be highly rewarding, but it also comes with tax implications that can eat into your returns. One strategy to minimize your tax liability and maximize your after-tax returns is Capital Gains Harvesting.
This technique of Capital Gains Harvesting involves strategically selling or moving investments to realize capital gains in a tax-efficient manner. In this blog post, we’ll break down what capital gains harvesting is, how it works, and provide an Indian example to help you implement this strategy effectively.
What are Capital Gains Harvesting
Capital Gains Harvesting is a tax optimization strategy where investors sell investments to realize capital gains in a way that minimizes their tax liability. The goal is to take advantage of lower tax rates or exemptions, such as the ₹1.25 lakh annual exemption on long-term capital gains (LTCG) for equity investments in India.
What are Capital Gains
Profits earned from the sale of a capital investment (e.g., stocks, mutual funds, real estate) etc.
Short-Term Capital Gains (STCG): Gains from the sale of an investment held for less than 1 year (for equity shares) or less than 2 years (for other assets like real estate).
Long-Term Capital Gains (LTCG): Gains from the sale of an investment held for more than 1 year (for equity shares) or more than 2 years (for other assets).
How Does Capital Gains Harvesting Work
Realizing Gains Strategically:
Sell investments that have appreciated in value to realize capital gains.
Use the ₹1.25 lakh annual exemption on LTCG for equity investments to minimize tax liability.
Rebalancing Portfolio:
Reinvest the proceeds from the sale into the same or other investments to maintain your desired asset allocation.
Tax-Loss Harvesting:
Combine capital gains harvesting with tax-loss harvesting (selling investments at a loss to offset gains) for maximum tax efficiency. The net gains are what matters.
Advantages of Capital Gains Harvesting
Reduces Tax Liability: By realizing gains within the ₹1.25 lakh annual exemption limit, you can minimize your tax burden. If you do not use the ₹1.25 lakh annual exemption, this exemption does not get carried over the next year and is hence wasted.
Improves After-Tax Returns: By optimizing taxes, you can maximize your overall returns.
Portfolio Optimization & Simplification: Helps you rebalance as well as simplify your portfolio and focus on better-performing investments.
Rules for Setting Off and Carry Forward of STCG and LTCG
Loss from Capital gains (long term or short term) cannot be adjusted against any other head of Income, however loss from other heads of income can be adjusted against any other capital gains.
Short Term Capital Losses are allowed to be set off against both the Long-Term Gains and the Short-Term Gains.
Long Term Capital Loss can be set off only against Long Term Capital Gains.
If you are not able to set off your entire capital loss in the same year, both short-term and long-term loss can be carried forward for 8 assessment years immediately following the assessment year in which the loss was first computed.
Capital losses from a Capital Asset like Real Estate can also be set off against gains from another Capital Asset like Equity.
Important Points to Consider while Harvesting Gains
Calculate Net LTCG: Be very careful not to ignore the adjustments of Short-Term or Long-Term Capital losses (as per the adjustment rules above) before arriving at your net Long Term Capital Gains for the financial year. Harvesting of Long-term Capital Gains should therefore be considered on the net long-term gains.
Move Fast: Selling investments solely for tax purposes can backfire if the market moves against you. Therefore, the sale and purchase should be done with a minimum time gap - preferably in a single day [Read the Single Day Movement Strategy in the FOOPS! book]
Move Rarely: Frequent buying and selling can lead to higher brokerage fees and other transaction costs. So, make sure that you do not try to harvest too often. This is typically a once-a-year movement to save taxes, typically done close to the end of a financial year when you have the maximum clarity on your capital gains so far. If you have already sold some equity assets this year and realized gains worth Rs. 1.25 lacs, then you may want to ignore this blogpost for this year.
Rebalance: Reinvesting proceeds while maintaining your desired asset allocation can be complex if you change your asset classes. So, exit and enter immediately in the same or different asset class depending on your current portfolio balance. Remember that maintaining the right portfolio balance on all asset classes (and not only with the equity asset class) is vital. e.g. if your equity is over balanced and commodity is under balanced, you may want to move funds from equity to commodity asset class while utilizing these gains harvesting techniques.
Enhance Portfolio Performance: If your equity investments are doing well, then harvest and reinvest back in the same asset. If some of the equity investments are not doing well, then harvest and reinvest in a better performing asset. This will enhance the overall performance of your portfolio.
Move from Regular to Direct, Dividend to Growth: Every inflow and outflow of funds can be converted into an opportunity. Use this tax harvesting as an opportunity to move from Regular funds to Direct funds (if you still hold regular funds) and also to move from Dividend Funds to Growth Funds (if you still hold dividend funds).
Be Aware of LT to ST Switch: Whenever you harvest, you typically convert the harvested stocks or units from Long Term to Short Term. As you are aware, that taxes on STCG is more than that on LTCG. So, be sure that you do not need the assets at least for the next one year, else you might come into the STCG tax bracket.
Example
Suppose you invested Rs. 2 lacs (Rs. 2,00,000) at the beginning of Year 1, and plan to liquidate the investment at the end of Year 3.
For the sake of simplicity and ease of understanding, let us assume that the investment grows during the 3 years consistently.
The below Figures show you the notional gains at the end of each year, and then the tax applicable when you liquidate the investment at the end of year 3.
Case 1 (No Gains Harvesting):
If you do not harvest your gains every end of the year, then you will be liable to pay a tax of Rs. 25,625 on this investment when you liquidate it at the end of Year 3.
Case 2 (Gains Harvested every year):
If you harvest your gains every end of the year, then you will be liable to pay no taxes on this investment when you liquidate it at the end of Year 3.
Summary
Capital gains harvesting is a powerful tax optimization strategy that can help you minimize your tax liability and maximize your after-tax returns. By strategically selling investments to realize gains within the ₹1.25 lakh annual exemption limit, you can optimize your taxes and improve your overall financial outcomes.
Whether you’re a seasoned investor or just starting your journey, understanding and implementing this strategy can help you build a more efficient and profitable investment portfolio.
Reference Links
- 📖 Book: From the Rat Race to Financial Freedom
- 📖 Book: FOOPS!
- 📖 Book: The Autobiography of a Stock
- ✍️ Blogpost: Mutual Fund SIPs and their Capital Gains Taxation
- 📹 Video: Move from Regular to Direct Funds
- 📰 Newsletter: Elevate Monthly Newsletter
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