Tax loss harvesting: How to use bear markets to save tax

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Stock prices have fallen to new lows lately after rising to dizzying heights in October 2021. If you own a portfolio of stocks or equity funds, it can be quite painful to see the handsome gains of a few months ago evaporate, to leave you with single-digit returns or even losses. But there’s a trick that seasoned investors use to turn such painful phases to their advantage. It’s called tax loss harvesting.

Tax loss harvesting, tax, how to save tax, capital loss

Tax loss harvesting

Tax Loss harvesting is the practice of selling a stock or mutual fund that trades below your buy price, so that you can convert the notional losses you see on paper into real losses. While this may sound like a strange thing to do, smart investors do it to save on tax outgo. 

A tax loss harvesting strategy can only be used in a year where the markets climbed high enough to allow you to book capital gains on some of your equity holdings and also plunged low enough to sink some of your holdings into the red. The financial year 2021-22, which ends in ten days’ time, has been just such a year.

How tax loss harvesting works

Under Indian tax laws, you are liable to pay capital gains tax on profits booked on your equity fund and stock holdings every financial year. The rate of tax depends on whether your capital gains are treated as short term or long term. 

If you’ve held a stock or mutual fund for over 12 months from the date of purchase, any gains made over cost price are treated as long-term capital gains (LTCG) and taxed at 10%. (Upto Rs 1 lakh of LTCG in a year is tax-exempt and gains made upto January 31 2018 are not considered for taxation). If a stock or equity fund has been held for less than 12 months, the gains you book are treated as short term capital gains (STCG) and taxed at 15%.

Now, the law requires you to pay STCG or LTCG tax only on your net capital gains. So, if you book capital losses on your equities within the same financial year as the gains, you can set the losses off against gains, before calculating your tax liability. Do note that the set-off applies only to losses you actually realize and not to the notional losses you see on your portfolio.  

This is what opens the doors to tax loss harvesting. To illustrate, suppose you are sitting on long-term capital gains of Rs 5 lakh and short-term capital gains of Rs 4 lakh for FY22 and see unrealized capital losses of Rs 3 lakh on your long-term holdings and Rs 2 lakh on your short-term holdings today. If you book these losses before March 31, you will need to pay tax only on Rs 4 lakh of capital gains instead of Rs 9 lakh earlier.  

In years where the stock market has made a new high (like FY2021-22), most investors would be sitting on either a LTCG or STCG tax liability. If you’re in this position, you can consider tax loss harvesting before March 31st 2022.

How to do it

  1. Check the capital gains report for FY22 that your broker or fund platform has made available on your account. Apart from your total capital gains, note the break-down between STCG and LTCG, after applying grandfathering and other concessions. This tells you the amount of losses you’ll need to book.   
  2. Scan your stock or equity fund portfolio to identify individual holdings that currently show unrealized losses. Most brokers/platforms provide this information on a readymade basis. Look for holdings with the highest absolute losses and sell them before March 31. 
  3.  If you’re selling only part of your holdings, be aware that the FIFO method (First In First Out) is applied to calculate your cost of acquisition. This could lead to your booked losses being slightly higher or lower than what you saw on your statement.  
  4. Identify which sales lead to short-term capital loss and which lead to long-term capital loss, based on your buy date. While selling, restrict your long-term loss-booking to the amount of long-term capital gains you have for set-off. This is because STCG and LTCG have slightly differing set-off rules. While short-term losses can be set off against either LTCG or STCG, long-term capital losses can be set off only from LTCG. 
  5. From your sell list, buy back the stocks or funds you intended to hold in your long-term portfolio from the market. Ensure the buy price is close to or below your sell price. This will ensure that your portfolio is reset to its original position, after tax loss harvesting. Given T+2 settlement, you may have to wait for a couple of days to receive the funds into your account before you re-acquire your sold positions. 
  6. Generally, bear markets are a good time to buy, not sell equities. If you’ve sold a significant chunk of your equity portfolio to harvest losses, make sure you refill your portfolio quickly to maintain your equity allocation. The identity of stocks or funds you buyback need not be the same as the ones you sold. But don’t wait for too long to refill, as a market rebound can lead to missed opportunities on acquiring good stocks/funds at a beaten-down price.

Behavioural benefits

Apart from reducing your tax outgo, tax loss harvesting is a behaviourally a good strategy to follow in bear markets too.

#1 Breaking out of loss aversion

When they see stocks or funds trading in the red, retail investors are often inclined to either stop looking at their portfolio altogether or to convert their loss-making positions into ‘long-term’ holdings. This is called loss aversion. Loss aversion prevents investors from admitting to their mistakes and correcting them promptly. In fact, many retail portfolios feature a long tail of loss-making stocks from the previous bull market that act as a drag on portfolio returns.

By giving you a positive reason (tax savings) to book losses on your underperformers, tax loss harvesting can help you break out of loss aversion, to make rational sell decisions on underperforming stocks or funds. If you have some Unitechs, Reliance Powers or Jaypee Infras from the 2008 bull run, tax loss harvesting can make you feel good about selling them at rock-bottom prices today, as you’d be using the losses to save tax.

#2 Cleaning up portfolio

Bear markets are often a great occasion for a portfolio clean-up, where you switch from low-quality to high-quality stocks that deserve to be long-term holdings in your portfolio. In a bull market, the prospect of quick gains often tempts you to clutter your portfolio with penny stocks, second-rung and third-rung stocks in a sector and tactical picks based on someone’s tips. But such holdings often prove a dead weight in the long run. Tax loss harvesting can help you get rid of such duds and free up cash.

You can use this cash to acquire better quality companies with sound long-term prospects.  You can check our Stock Ranking tool to know the health of your stocks across quality, growth and valuation parameters or use our recommended list of stocks –  Prime Stocks – for fresh investments. You can use our MF review tool to know whether the funds you hold are a buy, hold or sell.

#3 Rebalance allocation

Bull markets are times when many of us are prone to allocation and position-sizing mistakes. Carried away by a soaring Sensex, we may have gone whole hog on equities or risky classes of equities such as small-cap stocks. We may have acquired uncomfortably high portfolio weights in companies or sectors we don’t really have high conviction in. Tax loss harvesting is an opportunity to correct such mistakes too.

#4 Reset price

Finally, booking out of your loss-making positions also resets the buy price of your stock or mutual fund to current market levels. Logically, every time you take stock of your portfolio, it is good to start off with a clean slate. The market after all doesn’t care about your buy price for a stock or a fund and will only value it for what it thinks about its future value. By wiping clean your bull-market buy prices for stocks or funds, tax loss harvesting helps you make rational decisions based on current market prices.

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26 thoughts on “Tax loss harvesting: How to use bear markets to save tax”

  1. Hello,

    Thanks for the article and the timely idea.

    I am not able to be sure what’s the minimum period needed between sell and buy that’s done for tax harvesting and the precise reason for it.

    * Most of the articles say sell today and you can buy back the next day. However:

    1) Zerodha’s following article asks that share be bought back 2 days after selling. Reason it gives is “Two days because that is the settlement cycle when you buy or sell stocks—it takes 2 days for the stock to be debited from your demat.” (https://zerodha.com/z-connect/console/tax-loss-harvesting-opportunity-for-fiscal-year-fy-2021-22)

    * Is 2-day gap being suggested assuming the funds needed to buy back will come from the sell only at T+2? Or, is there a need for 2 days gap for the pair of txns to be considered non-speculative in nature?

    2) Suppose I have two DMAT accounts for my PAN. If I sell the stock to book loss in one DMAT account and on the same day / same time buy back the stock in the same quantity in the second DMAT account, is there any issue from tax loss harvesting management point of view? Doing it this way reduces the potential price fluctuation risk that’s there when done on different days.

    Thanks in advance.

    1. If the sell and buy are on the same day it may possibly be interpreted as a speculative transaction by the taxman, so a gap is advised. Two days to get the funds credited from the sale. Using diff demats may not help as today tax dept analytics can trace taxpayers using common pan/address etc.

      1. Thanks for replying and sharing your views. So, a gap of 1 day is sufficient rules-wise (if sell proceeds availability is not a dependency)?

  2. Anandkumar Mehta

    Hi Arati

    Thanks for the timely article. Please can you clarify if Dividend income earned during the year can be offset against capital losses?

  3. Thanks Aarati,
    I think I will use this method henceforth. I have.neen holding my portfolio for long time & carrying losses with out setting off the gains. Thanks !

  4. Thanks for this timely article, Aarati. I use Zerodha and funds typically come to the account the next day. So can I go ahead and by the stocks back the next day (T+1)?

  5. Gopalakrishnan CS

    The article doesnt mention bonus stripping to adjust losses. Can you please clarify if this can be done ? Thanks

  6. Thanks for this timely article. I am a little confused though. As suggested in your article, when I check with my MF capital gain statement, it shows one column – Long Term Capital Gain “with indexation” as Nil and another column “without indexation” shows some amount as Gains. What does that mean? Which one should I consider?
    Will be thankful for a clarification.
    Thanks

    1. If you’ve booked capital gains on equity funds or stocks it’s not eligible for indexation. This could be what the stmt is referring to. If it is equity gains you can use loss harvesting to reduce the tax liability through setoff.

      1. Thanks for the clarification. That means I am having STCG in Mutual Funds already booked / sold, which, as per your article, can be adjusted if I book a loss by selling off some equity which is currently below my purchase price. Hope my understanding is correct.

        1. Yes, do confirm if it equity or debt capital gains once more bcos am not sure how your platform discloses this info. Usually a list of funds on which you booked gains will also be available.

  7. Can you help me understand it – if I have Salary income + I have capital gains from direct equities and equity MFs as well then which ITR form I have to submit – is this ITR1 or ITR2.

  8. This is not tax loss harvesting. you are just deffering taxes from current year to future year. For e.g. If my buy price is 100 I am selling at 90 to book loss but when I am buying back at 90 whenever I sell in future, i will have 10 worth of additional gain on which I will have to pay tax in future. Please dont give wrong information.

    1. No one is misleading anyone here. One, here you are setting off losses against already booked gains for the current fiscal. Two, if you are a long term investor you can’t perpetually escape tax. You will need to pay it some time..when you book losses in a year where you have high capital gains you get a setoff advantage, is all we are saying. Three you will be deferring tax only when you buy back the same stock at the same price. As the article mentions there are often cases in the portfolio where you simply book losses and don’t rebuy the same position. This is precisely why we highlighted the behavioural aspects too in this article.

  9. I wish this article was there last year when I was in this situation 🙂 Is there a limit on how much losses can be set against gains?

    1. Great article Aarati.
      Suggestion – maybe you could also cover equity GAIN harvesting, i.e. the practice of harvesting LTCG upto 1 lakh in current FY (by selling stocks and immediately buying back), to reduce that 1 lakh from future gains and thus reduce future LTCG tax.

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