Everybody agrees that long-term gains are almost always preferable to short-term gains. I tend to agree in general. But there are exceptions too for example if you are a retired person like me :). Long term capital gains taxes are lower than the short-term counterparts. For example, short-term capital gains tax on equity is 15% vs 10% on long-term gains. Likewise, debt short-term capital gains are taxed at your applicable tax rate as opposed to 20% on indexed long-term capital gains.
And here is your exception if you read carefully. What if your applicable tax rate is less than 20%? This is possible if you are like me, retired with no other income except from mutual funds. For this reason, I churn a portion of my corpus to always have short-term gains. Lets see how this works.
The minor benefit of short-term gains
One thing to remember is that it works only if you have no other income. So if you are a salaried person or have some income from rent etc, then it may not work depending on how much you are earning. And even when it works, the benefits are so minuscule that it is probably not worth the effort. On top of that, your portfolio will be a bit more cluttered. So unless you have no work like me and don't mind a dirty portfolio, don't bother with this idea.
Now for an example with and without short-term gains. Lets say I sold some debt MFs due to which I incurred a long term capital gain of Rs. 6.5 lakhs after indexation. Then using the income tax calculator one can find out that the tax I am liable to pay is Rs. 83,200 for the FY 2020-21.
Now lets run a different experiment. Lets says I sell some debt MFs due to which I incur a short term capital gain of the same Rs. 6.5 lakhs. The tax liability comes down to zero. This is one of those rare cases where short-term capital gain are preferable to long term ones. I will explain how.
A short-term debt capital gain becomes part of your regular income. And we know Rs. 2.5 lakhs of the income is exempt from taxes. Out of the remaining Rs. 4 lakhs we can opt for Rs. 1.5 lakhs deductions via section 80(c). Now we are left with Rs. 2.5 lakhs of taxable income. The tax comes out to be Rs. 12,500. Thankfully there is a tax relief u/s 87A of up to Rs. 12,500 if the total income after deductions is less than Rs. 5 lakhs. In our case the total income after deductions is Rs. 5 lakhs (Rs. 6.5 lakhs - 1.5 lakhs). So the next tax is zero.
For this reason, I maintain different folios for short-term and long-term gains even when I am investing in the same fund. Likewise, having a short term equity fund is helpful in the cases where you have short-term losses which you can offset against other short-term or long-term gains. Moreover you can carry forward your losses for the next 8 years in case you are unable to offset all of your losses. I have used this to good effect in the past when I lost money in a stock.
The downside of this whole process is that your need to spend more time and effort to maintain and rebalance the folios. The other problem is that your portfolio will be a bit of a mess with multiple folios for the same fund. Anyway I don't mind the mess or the effort needed. Remember I am retired and have no work :). For salaried this will be a useless exercise.