It’s that time of the year when investors start looking for legal ways to reduce their tax bills. Tax loss harvesting is one such strategy.

It’s the practice of selling loss-making investments and using those losses to offset gains elsewhere, reducing the overall tax liability.

This approach can also be used to remove underperforming funds from your portfolio, all while reducing your tax bill through tax loss harvesting.

How it works

Imagine holding two equity mutual funds. One has slipped from ₹20 lakh to ₹18 lakh, leaving you with a ₹2 lakh notional loss. The other has climbed from ₹10 lakh to ₹14 lakh, giving you a ₹4 lakh gain.

Now, if you want to redeem the scheme with the gains, then you have to book a Rs 4 lakh profit. Assuming the fund qualifies for long-term capital gains tax, you effectively pay tax on ₹2.75 lakh of profit. For context, LTCG up to ₹1.25 lakh on stocks and equity mutual funds is tax-free.

By using tax loss harvesting, here’s how you can optimise your capital gains tax.

You can sell the loss-making scheme and book a ₹2 lakh loss, which can be set off against your ₹4 lakh gains. This reduces your taxable gains to just ₹75,000 (₹2.75 lakh – ₹2 lakh), compared to ₹2.75 lakh earlier.

So instead of fretting over choosing the wrong fund, that loss-making scheme can actually help you save some taxes. All thanks to tax loss harvesting!

• Before tax loss harvesting: ₹34,375 tax
• After tax loss harvesting: ₹9,375
• Tax saved: ₹25,000

Going forward, if you reinvest the proceeds from the loss-making investment into a new fund and assuming it doubles, your ₹18 lakh would grow to ₹36 lakh, making you liable to pay tax on the ₹18 lakh gain.

For a second, let's assume that you never sold the loss-making fund that you had used for tax loss harvesting, and it also doubled just like the other fund.

Now you might be thinking: If I hadn’t sold the loss-making fund, I would have paid less tax in the future and offset the earlier savings over time? After all, your ₹20 lakh investment would have grown to ₹36 lakh, same amount of gains in future compared to if you had used tax loss harvesting.

Is that really the case? Not quite. With everything else equal, the total tax may be same, but money saved today is more valuable than the same amount in the future due to inflation.

Not to mention, if you’re looking to exit loss-making funds or stocks, tax loss harvesting provides a clean, tax-efficient way to do so.

In fact, if you had used the losses to offset short-term capital gains, which are taxed at a higher rate of 20% and do not benefit from the ₹1.25 lakh exemption, you can achieve immediate tax savings if your future investments qualify for long-term capital gains when sold.

Another common strategy is to realise long-term capital gains from listed stocks and equity mutual funds while keeping gains within the ₹1.25 lakh exemption limit, allowing profits to be booked tax-free. Reinvesting the proceeds in the same fund resets the cost base higher, helping reduce future capital gains tax.

Things to keep in mind

Remember that if you fail to file the ITR by the due date (July 31st), then capital losses cannot be carried forward.

If the losses exceed the gains in that financial year, there is no need to panic. Any remaining losses can be carried forward for up to eight assessment years and used to offset capital gains in the future, provided the tax returns were filed on time.

While short-term losses can be used to set off against both long-term and short-term gains, long-term capital losses can only be used to offset other long-term capital gains.

Note: Losses from investments cannot be used to set off against salary income.

Moreover, if you sell a stock or MF to book losses and buy the same stock/MF on the same day, it will be considered an intraday trade and taxed as speculative income. Such losses cannot be set off against other heads of capital gains.

There are rules on what kind of capital loss can be used to offset against gains. For instance, intraday losses can only be adjusted against intraday gains and are not eligible to set off against other types of gains.

Ionic View

Tax harvesting separates the investor who actively manages their portfolio from one who merely holds it. Both may hold identical portfolios, yet the active investor steadily trims their tax liability while the passive investor defers it all, until exit triggers a larger tax outgo.

However, booking losses to offset current or future gains makes arithmetical sense, but the obsession with tax harvesting can quietly turn a long-term investor into an accidental trader.

The line, therefore, is simple: use tax harvesting when it aligns naturally with your portfolio decisions, not when it forces you to exit.

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With the Ionic App, you can get a detailed scheme wise and category wise breakdown of your long term and short-term holdings, to identify funds which can offset your gains with losses.

To access this information, go to the Mutual Funds section on the Ionic App, navigate to Tax Loss Harvesting, refresh your holdings and download your report.

With inputs from Hardik Mehta, Lead-Tax at Ionic Wealth