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 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
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
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.