tax harvesting - what_when_how
tax harvesting - what_when_how

Tax Harvesting – Smart way to reduce taxes

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  • Post category:Taxes
  • Post last modified:February 1, 2022
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Everyone wants to save tax. And one smart way to save taxes on profits from Stocks and Mutual Funds is via Tax Harvesting. In this article, I will explain you what Tax Harvesting is and how you can benefit from it??

Before we go on to Tax Harvesting, let us spend a minute to understand Capital Gains and their taxation. The profits made from buying and selling equities (like Stocks, Mutual Funds) are known as Capital Gains. If the holding period between buying and selling is less than one year, the profits from those are known as Short Term Capital Gains STCG (or Short Term Capital Losses STCL). For above one year holding period, you will have Long Term Capital Gains LTCG (or Long Term Capital Losses LTCL).

Taxation on these LTCG and STCG is treated differently. For LTCG, capital gains below 1 Lakh rupees per year are tax free and there is 10% tax on capital gains beyond 1L rupees. For STCG, there is flat 15% tax irrespective of the capital gains.

Image 1 - Taxation on LTCG and STCG
Image 1 – Taxation on LTCG and STCG

Now that we know basics of LTCG and STCG, let us come back to Tax Harvesting.

What is Tax Harvesting

Tax Harvesting is a technique of selling and buying stocks/mutual funds which allows you to reduce your tax outgo.

Concept of Tax Harvesting is very similar to agriculture. In agriculture, farmers harvest their crops, sell them, book profits (or losses if crops are damaged) and grow the crops again for next year. Similarly, in tax harvesting, you will be selling stocks or mutual funds (harvesting), booking profits (or losses) and buying new stocks/mutual funds for next year/future.

How To Do Tax Harvesting

Doing Tax Harvesting is a simple process. There are 4 parts to it:

  1. Selling and Buying the stocks/mutual funds
    • For stocks you want to hold
      • Sell the stock on one exchange (say NSE) and buy it back on other exchange (say BSE) after few seconds
    • For stocks you no longer want to hold
      • Sell the stock to book profits or losses and buy something else
  2. Calculating LTCG/STCG/LTCL/STCL
    • Split the profits/losses made from above transactions into long term (for stocks sold after 1 yr holding period) and short term (for stocks sold before 1 yr holding period).
  3. Adjusting losses against gains
    • Adjust any STCL against STCG or LTCG. Adjust LTCL only against LTCG.
Image 2 - Adjusting Gains against Losses
Image 2 – Adjusting Gains against Losses
  1. Pay taxes @ 15% for STCG and 10% on LTCG above 1 Lakh.

Note – Tax is applicable only when there is profit. For LTCL/STCL, tax will be 0.

Let us understand these with one example.

Let us assume that Mishraji and Sharmaji are 2 friends. Both of them had purchased 1000 shares of Tata Motors on 1/1/2019. Sharmaji sold 1000 shares on 1/1/2020 and purchased back 1000 shares again on same day while Mishraji did not do anything in 2020. Then on 1/1/2021, both sold all their shares.

Image 3 - Tax Harvesting - Who saves more tax?
Image 3 – Tax Harvesting – Who saves more tax?

Tax calculations will be as follows for Mishraji and Sharmaji:

  • Mishraji –
    • Cost price (2019) = 1L, Selling price (2021) = 3.5L
    • Since stock is held for over 1 year, LTCG will be applicable. LTCG = 3.5 – 1 = 2.5L
    • Tax = 10% of profits above 1L = 10% * (2.5 – 1) = 15K
  • Sharmaji –
    • Cost price (2019) = 1L, Selling price (2020) = 2L
    • LTCG in 2020 = 2 – 1 = 1L
    • Tax in 2020 = 10% (1 – 1) = 0
    • Cost price (2020) = 2L, Selling price (2021) = 3.5L
    • LTCG in 2021 = 3.5 – 2 = 1.5L
    • Tax in 2021 = 10% (1.5 – 1) = 5K

Thus, by doing a simple trick of selling and buying share, Sharmaji was able to reduce his taxes by 10K while booking the same profits.

Note – It is not necessary to buy back the same share. You can also just sell the share if you want to remove it from your portfolio.

Related ReadWill Tax Harvesting work in Falling market or Rising market?

Why should Tax harvesting be done

Tax Harvesting can benefit you in the following way:

  • Reduce Capital Gain Taxes
  • Clean up your portfolio by removing under-performing stocks and buying good stocks.
  • Book profits while retaining the stock/MF
  • Reduce the average cost price so that higher profits can be obtained in future
  • Reduce tax outgo as losses can be adjusted against profits made in next 8 financial years (provided you declare in ITR)

Conclusion

With growing awareness about stocks and mutual funds, many people have now started investing in these. Tax Harvesting will help everyone book profits and reduce their taxes.

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