Simply put: Tax Loss Harvesting

It’s the year-end. Yash and Chaitanya catch up over coffee to discuss how they can plan their taxes for the year.

Yash: Hey, taking your advice last year, I have bought some tax-saving investments. But my tax liability is still high.

Chaitanya: Really! Why so?

Yash: I sold a stock which I was holding for a long time. Now that long-term capital gains are subject to tax, here I am with a huge tax burden this year. What should I do?

Chaitanya: But then, up to ₹1 lakh of gains, there’s exemption, right?

Yash: Mine is exceeding the threshold.

Chaitanya: No worries. There’s always tax loss harvesting you can rely on.

Yash: What’s that?

Chaitanya: You might have some ‘dud’ stocks in your portfolio and these stocks can possibly never get back to the price at which you bought, let alone make money for you. Now is the time to use such loss-making stocks. So this year, when you’ve incurred capital gains, especially long-term capital gains, it will be a good idea to get rid of these dud scripts and utilise the capital loss to reduce the tax liability. This way of reaping benefit from underperforming stocks is called tax loss harvesting.

Yash: So, we intentionally book these losses to reduce tax bill?

Chaitanya: Yes, that is the aim here. In fact, when investors are able to estimate that even in the next assessment year, their capital gains may be high, it’s a common practice to buy back or repurchase the shares sold. This way you are creating a buffer for loss harvesting. Essentially, it implies that the same shares are brought back at around the sale price and gets added back to the portfolio. I’ll tell you how this helps.

Yash: Ok, but before that let me be sure that I’ve understood the concept of tax loss harvesting.

Chaitanya: Go on.

Yash: Let’s assume that for the current assessment year, I have long-term capital gain of ₹1.75 lakh short-term capital gain of ₹ 1.25 lakh and a short-term capital loss of ₹50,000. So, the tax liability would work out to ₹26,250. That is without using the capital loss. Here’s the computation: [(1,75,000-1,00,000) *10%+(1,25,000*15%)] = ₹26,250

But if I utilise the capital loss, the tax burden reduces to ₹18,750. [(1,75,000-1,00,000) *10%+((1,25,000-50,000) *15%] = ₹18,750.

Right?

Chaitanya: Correct! Also remember some basics of the set-off rules in capital gains. Long-term capital loss can be set off only against long-term capital gain. But short-term capital loss can be set off against short-term capital gain or long-term capital gain. Remember I told you about buying back the stock you’ve sold? People do it with the assumption that the stock will continue to be a loss-making one, which will give an opportunity to set off against capital gains in the subsequent year(s).

Yash: I’m not convinced on the repurchase or buy back part. Is it mandatory to do so?

Chaitanya: It is not mandatory. First, an investor should take stock of the portfolio. The decision to repurchase should be taken only if the investors expect to accrue capital gains in the future. So, the repurchased shares will once again help save taxes. If one isn’t sure how the portfolio will play out, then it is better to avoid this step.

While repurchasing the shares, you are essentially making two assumptions. One, the dud stock you bought back will continue to be an underperformer. Basically, you hope the stock to be a hopeless one. Second, you will be able to buy back the stock at or near-about the price it was sold. If either of the assumptions go wrong, the purpose of repurchasing the stock will be defeated. You would have unnecessarily piled on to the stock that you weren’t keen on.

Yash: But is loss harvesting as easy as it sounds?

Basic set-off rules

Long-term capital loss it can be set off only against long-term capital gain.

Short-term capital loss can be set off against short-term capital gain or long-term capital gain.

Buy back the stock only if it will continue to be a loss-making one, giving an opportunity to set off against capital gains in the subsequent year(s).

Chaitanya: Not quite. The sales proceeds do not credit into your account immediately and therefore to buyback the shares at the selling price you need to have considerable cash in hand. Volatility in markets is a critical factor; it makes it difficult to buy back at the sale price, especially if the stock is historically an illiquid one. If the price has moved up from where you sold, then it’s redundant to repurchase the shares as you would be paying more money for what you sold. There is also brokerage involved. So, think before you decide to utilise the losses and think twice if you want to repurchase the shares.

Yash: Wow, I’ve learnt another method to save some taxes. Thanks!

Chaitanya: Now that you are richer by ₹7,500, the lunch is on you the next time.

Yash: Sure!

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