Everyone wants to maximize returns on their investment. When we invest in the equity market then we have one such hack which helps us in maximizing our returns. Don’t worry this hack is legal and valid in the stock market and we called it tax loss harvesting. Here we will provide a brief overview of how tax loss harvesting works and how it can help in saving taxes.
Tax loss harvesting is a method of reducing the tax to maximize profits. It is a strategy that uses the fact that capital gain can be offset by capital loss to reduce tax liabilities. It involves selling securities that have experienced a capital loss to offset the capital gains generated by other investments. By realizing losses, investors can use them to offset taxable gains and potentially lower their overall tax bill.
How to Manage Portfolio after Tax Loss Harvesting
Implementation of tax loss harvesting disrupts the portfolio, so it is important to manage your portfolio after tax loss harvesting so that it aligns with your investment goals and risk tolerance. Here are some steps to manage your portfolio after tax loss harvesting:
Replace/Repurchase the sold investments: If you sold investments as part of tax loss harvesting, you may consider reinvesting the proceeds in similar/same securities. In India wash sale rule is not present so the investor is free to repurchase the sold securities again.
Review investment performance: Evaluate the performance of your remaining investments. Consider factors such as historical performance, risk-adjusted returns, and alignment with your long-term investment goals. If certain investments are consistently underperforming or no longer meet your criteria, it may be appropriate to consider selling them.
Harvest future losses: Continuously monitor your portfolio for potential tax loss harvesting opportunities. Market downturns or specific investment underperformance may create opportunities to realize losses in the future, allowing you to offset future capital gains or reduce taxable income.
Wash Sale Rule
The wash sale rule is a regulation established by tax authorities, such as the Internal Revenue Service (IRS) in the United States, to prevent investors from claiming artificial or “wash” losses for tax purposes.
Here are the key points to understand about the wash sale rule:
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Definition: A wash sale occurs when an investor sells a security (such as stocks, bonds, or mutual funds) at a loss and, within a 30-day window, either buy back the same security or acquires a substantially identical security. The rule applies to both individual and substantially identical securities.
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Disallowance of Loss: If a wash sale occurs, the investor is not allowed to claim the loss for tax purposes.
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30-Day Window: The wash sale rule considers a 30-day period that includes the day of the sale and the 30 preceding calendar days. If security is repurchased within this window, the wash sale rule applies.
Example of Tax Loss Harvesting
Let’s take an example of tax loss harvesting:
Mr. X has a taxable investment portfolio consisting of individual stocks and mutual fund units. In the current tax year, Mr. X has realized long-term capital gains(LTCG) of ₹150,000 and a short-term capital gain of ₹50,000 from selling some of his profitable investments. However, he also has a few investments that have declined in value, resulting in unrealized capital losses. he wants to take advantage of tax loss harvesting to offset his capital gains and potentially reduce his tax liability.
Identify Assets with Losses and Profits:
- Stock A: Purchased for ₹25,000, currently valued at ₹6,000, resulting in an unrealized loss of ₹19,000, held for 200 days.
- Stock B: Purchased for ₹60,000, currently valued at ₹40,000, resulting in an unrealized loss of ₹20,000, held for 150 days.
- Mutual Fund C: ₹40,000 unrealized gain, held for 400 days
- Mutual Fund D: ₹20,000 unrealized loss, held for 370 days
Sell Assets with Losses:
- To realize the losses for tax purposes, Mr. X decided to sell all shares of Stock A and Stock B which will realise the STCL and he also sold his Mutual fund C and D to realize the LTCL.
Offset Capital Gains:
- He used the realized short-term capital losses from Stock A and Stock B, totalling ₹39,000, to offset his short-term capital gains of ₹50,000.
- After offsetting, his net short-term capital gains were reduced to ₹11,000.
- In a similar way after realising the long-term capital loss by selling Mutual funds C and D, the realised capital loss is ₹60,000. He can offset the long-term capital gain of ₹150,000. Now the LTCG after offsetting the LTCL is ₹90,000.
- Taxes before and after tax loss harvesting:
- Before tax loss harvesting LTCG is ₹150,000 out of which the first ₹100,000 is tax-free and he needs to pay taxes on ₹50,000 which will be 10% of ₹50,000 = ₹5,000 and after tax loss harvesting the LTCG becomes ₹90,000 which is below ₹100,000 and it is tax free.
- STCG is ₹50,000 on which 15% tax is ₹7,500. After tax loss harvesting STCG reduced to ₹50,000 -₹39,000 = ₹11,000. Tax on reduced STCG is 15% of ₹11,000 which is ₹1,650.
Deduct Remaining Losses:
- If an unrealised capital loss is greater than the realised capital gain then after offsetting the capital gain the remaining capital loss can be carried forward to the future.
By implementing tax loss harvesting in this example, Mr. X saved a total of ₹10,850. ₹5,000 from tax on LTCG and ₹5850 from tax on STCG.
Words of Wisdom
“Do not save what is left after spending; instead spend what is left after saving.” ― Warren Buffett
Key Takeaways
- Tax loss harvesting is a long-term strategy that can provide both immediate and future tax benefits. This is achieved by carrying forward the losses.
- STCG and LTCG can only be set off against the STCL and LTCL respectively.
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Portfolio rebalancing and replacement of sold investments should be considered after tax loss harvesting.
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In India wash sale rule is not present.
Conclusion
Tax loss harvesting is a strategy that can be beneficial for investors looking to reduce their tax liability. This is generally done at the end of the year to reduce the tax liability and maximize profits. This method used the fact that LTCG and STCG can be offset with the help of LTCL and STCL respectively.
Thank you for taking the time to read this blog post! I hope you found the information helpful and informative. If you have any thoughts or feedback, I’d love to hear from you in the comments section below. You can also follow me on social media to stay up to date with my latest posts and updates.
