There are lots of legitimate ways to reduce taxes and tax loss harvesting is one of them. However, in practice, it is much harder to execute. But before we get ahead of ourselves, let me explain what tax loss harvesting is in case you don’t know. Tax loss harvesting is nothing but selling your investments for a loss when the value is below your invested amount. Then use the losses to offset any other capital gains or income that you might have. Generally tax loss harvesting works well with equity markets because there is a possibility that the markets fall and your investments could be worth less than what you invested.
Let me give you an example. Lets say you invested Rs. 5 lakh into an equity mutual fund last month. Today lets say the value went down to Rs. 4 lakhs. This happens all the time in equity markets, so nothing strange about it. Now if you were to sell your investments, you will have Rs. 4 lakhs deposited in your bank. So you had a loss of Rs. 1 lakh. Simultaneously at the time of redeeming your investment, lets say you also invest Rs. 4 lakhs into the same mutual fund. Then your investment is again Rs. 4 lakhs. So your investments remain the same and your bank balance remains the same after the sell and buy transactions have been completed.
So what is the advantage of doing this whole dance then? Well, lets say that your income from salary or due to FDs or any other capital gains is Rs. 10 lakhs in that financial year. Then you can offset the loss from your gains/income. So your actual taxable income will become Rs. 10 lakhs - Rs. 1 lakhs = Rs. 9 lakhs. So instead of paying taxes for Rs. 10 lakhs income, you pay tax for Rs. 9 lakhs thus saving you taxes. And all your investments are intact. So by doing those two transactions of selling and buying, you saved tax while changing nothing in terms of investments. Well, technically your investments have a new date, which means you have to wait longer to consider than as long term gains, but that is fine.
On the topic of long term gains, do note that any long term capital loss can only offset long term capital gains. So in the above example, if your investments were more than 1 year old in the case of equity investments, your loss is long term and it can only offset long term capital gains. So you cannot offset your salary or FD interest etc. Only if you have another long term gain can you offset it. But all is not lost. You can carry forward your losses for the next 8 years, and if you have any long capital gains in future, you can offset those. However, short term loss can offset both long term and short term gains.
The topic for this blog came because I had recently executed a tax loss harvesting strategy to some effect. I have done tax loss harvesting the past too. However, there are problems with this strategy. First, you should know that there is going to be a fall in the market in the near future so you can start a new investment and when the market falls you can sell from that investment. If you always use the same fund for investments, in the long term the old investments would have grown and would not allow you to sell for losses because when you sell investments in mutual funds, you always sell first-in, first-out. If you invest in stocks, you have the flexibility to sell any investment and take good losses.
So knowing when to start a new mutual fund investment is one thing. The second problem with tax loss harvesting (if you are using mutual funds like me), is that it increases the number of mutual fund folios in your portfolio. Normally when I figure out that there would be a market fall in the near future, I continue my usual investments in the same mutual funds, but in a new folio. That way, when I need to sell the investments for a loss, I start selling from the new folios. Now, if I get the timing wrong or if I am unable to sell all the investments from the new folios, I will just be bloating my portfolio with a bunch of folios. Managing the mess is a pain.
That was exactly what was happening to my portfolio. I have way too many folios of the same mutual funds. So I might have to stop doing this kind of tax loss harvesting. Just like I mentioned in one of my previous posts about planning to reduce my asset allocation swings, I am planning to reduce this activity too. Anyway, in the last financial year when I expected the markets to fall, I moved some money from debt mutual funds to equity mutual funds and later sold the equity funds to capitalize on the losses. My total short term loss was Rs. 2.5 lakhs which is quite substantial to offset some of my capital gains :).