Tax loss harvesting is a perfectly legal, above board way of optimizing your tax payments on capital gains. Ideally, it should be done through out the year, but here are a few things anyone who has exposure to equity/debt markets can do.
What is tax loss harvesting: If you have capital gains, whether in debt/equity/other assets, and you have shares or funds but in losses right now, you can consider liquidating them to reduce the extent of your gains. You can only set off long term losses against long term gains, but short term losses can be set off against both short/long term gains.
Making the best of Long term capital gain exemptions: In case of long term capital gains, In India, we have an exemption limit of INR 1 Lakh i.e. only gains above 1 lakh are taxed. It is a good idea to book long term capital gains upto INR 1Lakh to avoid the gains from piling up and then get taxed later when the asset is liquidated or the mutual fund is sold.
An example of this:
Let us say I invested INR 10Lakhs in an equity Mutual fund. For simplicity, lets assume my investment date was 15-March-2020. On 16-march-2021, the holdings will qualify as long term assets. Let us further assume that every year, this fund grows at 10%. I exit my holdings in this fund on 16-march-2023.
Scenario 1 - I hold till 16-March-2023 and sell: At that rate, on 15-March-2023, the holdings are valued at INR 13.31 lakhs. I will be effectively paying tax on 2.31Lakhs, since INR 1 Lakh is exempt. i.e INR 23,100/-
Scenario2 - I harvest tax upto 1 lakh every year (bear with me on this explanation below)
On 16 March 2021, I sell the entire holdings worth 11 lakhs, and book tax free profit of 1lakh, and reinvest the 11 lakhs in the same fund
On 16 march 2022 I sell part of my holdings valued at 11 lakhs again (whose cost is 10 lakhs), and book tax free profit of 1lakh, and again reinvest the proceeds. So My portfolio now has two parts - one where the cost base is 11 lakhs, and one where the cost base is 1 lakh (because I didn't liquidate the full thing)
On 16 march 2023, I sell everything I have worth 13.31 lakh. But the cost of these holdings are: 12 lakhs. My gain is 1.31 lakh, in which 1 lakh is now exempt, and I pay capital gain tax of INR 3100/-!!!
This is maximum you can gain (given it is based on a 1 lakh cap), but INR 20K is an easy saving for hardly 30 mins of work over the year.
How do I choose what loss-making assets to liquidate: If you are like me, there are some shares you have hung on to purely due to lethargy. I have some stocks I bought (like Jain Irrigation) which tanked by over 80% since my purchase. The current value is so low that It is a rounding off number in my portfolio. Selling part or all of those stocks (unless you have a conviction that the share will recover) is a good use of that stock.
Should I buy back the same stock/fund?: Really upto you. If you believe that stock will bounce back, go for it. If not, use this opportunity to cleanse your portfolio!
Have you done tax loss harvesting before?
Nope. And its not worth the time/effort either.
Yes. Why should I pay taxes when I can optimize them?
Nope, but I may try it sometime...