Making the Most of Market Dips By Harvesting Taxes

Like death and taxes, stock market crashes are a matter of when, not if. While crashes invariably cause pain, they also provide an opportunity to save on taxes by enabling tax loss harvesting.

But first, what is tax loss harvesting? The essential idea is that you sell investments that are incurring losses, and adjust those losses against capital gains from other parts of your portfolio. This reduces your net capital gains, thereby reducing your taxes. But if you are a long-term investor, you likely do not want to sell your holdings just because the market is temporarily down. How do you still benefit from tax harvesting?

You sell the stocks or mutual funds incurring losses but repurchase¹ them at the same price. The sell-and-repurchase may seem futile, but it locks in the losses on paper. This is incredibly valuable because the Indian IT Dept. treats all capital gains (or losses) as equal, irrespective of which asset class they arise from. You can, therefore, offset gains from an asset class taxed at a higher rate against one taxed at a lower rate. This, as you can imagine, can help you save significantly on taxes.

For instance, let’s say you have invested ₹1000 in equities and ₹1000 in debt. During a crash, the equity portion goes down from ₹1000 to ₹900, while the debt portion goes up from ₹1000 to ₹1100. By the time you liquidate the portfolio later, the stock market recovers and rises to ₹1100. Also, let’s consider that you’re in the 30% tax bracket.

Now, without tax harvesting, you’ll have to pay a total tax of ₹42.5 (12.5% LTCG tax on ₹100 equity gains + 30% tax on ₹100 debt gains). But if you had booked the temporary ₹100 loss in equity valuation, you would be able to offset this against the ₹100 debt fund gains. As a result, your tax liability would reduce from ₹42.5 earlier to just ₹25 (12.5% LTCG tax on ₹200 equity gains).

Another relatively well-known benefit of tax harvesting is being able to defer the tax payments to the future. Your tax outgo may not decrease, but you still benefit because of the time value of money—a topic we have discussed here. You can, of course, benefit from both the reduced tax rate as well deferred payments if you adjust the losses against long-term investments, which will be redeemed only in the distant future.

Key Considerations

There are a few other practical aspects to be aware of to make the most of tax harvesting:

• Capital losses can be short-term or long-term, just like capital gains. Short-term capital losses are more versatile than long-term losses, as you can adjust them against both short-term as well as long-term capital gains. Long-term losses, however, can only be adjusted against long-term gains.
• If you don’t have capital gains in a given year, you can still harvest the losses and carry them forward to be adjusted against future capital gains, for up to next 8 assessment years. Keep in mind that you must declare those losses while filing the tax return to be eligible for future adjustments.
• If you have been investing the money in just one folio, you may not be able to do tax harvesting due to the FIFO (First-In-First-Out) principle of mutual fund redemptions. You should split your future investments into multiple folios to work around this limitation for the future.
• Having a large stash of cash makes it easy to do tax harvesting transactions, but you can make do with a modest bank balance if you are willing to put in some time. We have discussed this here.
• Since market crashes also often create a need to rebalance the portfolio across the asset classes, portfolio rebalancing provides a natural opportunity to harvest taxes.