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The late Finance Minister, Mr. Arun Jaitley, reintroduced the long-term capital gains tax in the Union Budget 2018. Previously, capital gains on equity investments were tax-free if held for a year or longer before redemption. 

Indeed, mutual fund gains are currently taxable. Even if you cannot avoid taxes entirely, there is a way to reduce capital gains tax legally. Tax harvesting is the method used. 

The following sections explain w you can reduce your investment tax burden by using tax harvesting 

1) What is the Calculation of Capital Gains Tax on Mutual Funds?

You must first understand how mutual funds are taxed to reduce your capital gains tax burden. Mutual funds that are debt-oriented and mutual funds that are equity-oriented are taxed differently. Investing in and is subject to the following Capital Tax rules: 

  • Gains on debt-oriented mutual funds that are held for three years or less before redemption fall under the STCG category and are taxed as per your slab rate. Consequently, debt funds may incur capital gains tax of up to 30%.[Text Wrapping Break]Gains from Debt Fund units held more than three years before redemption are subject to the Long Term Capital Gains (LTCG) tax rate. The LTCG on debt fund gains is 20% with indexation. 
  • In the case of equity-oriented mutual funds, you will be taxed on short-term capital gains (STCG) after holding the fund units for one year before redeeming. 

The Equity-Oriented Mutual Funds: If you hold equity funds for up to one year before redeeming, your gains will be subject to short-term capital gains (LTCG) tax. Therefore, if you have total equity gains of Rs. 1.1 lakh in a year, only Rs. 10,000 of the gains are subject to 10% tax, while the rest is tax-free.

2) How can short-term gains be offset against capital gains tax?

Currently, neither equity mutual funds nor debt mutual funds are able to reduce your short-term capital gains tax. If you book short-term gains from debt mutual funds, you must pay capital gains tax according to your slab rate. 

Equity fund gains are also taxable if they are redeemed before the one-year mark. This means you must pay 15% capital gains tax if you redeem your equity investment before one year has passed.

3) What are the best ways to reduce the long-term capital gains tax on mutual fund returns?

When you redeem shares from Debt Mutual Funds, you will be eligible for indexation benefits. By staying invested in debt mutual funds for three years or more, you will be eligible for indexation benefits. 

Long-term gains are taxed if your equity mutual fund returns are more than Rs. 1 lakh in a given financial year. Therefore, if your long-term capital gains from equity mutual funds are below or equal to Rs. 1 lakh, you will not be subject to capital gains tax. As a result, the tax harvesting strategy is used by Equity Mutual Funds.

4) Reducing capital gains taxes with tax harvesting

Your long-term returns will be less than Rs. 1 lakh if you have only invested a small amount so far. In other words, you won’t have to pay long-term capital gains tax upon redemption. Your returns will exceed Rs. 1 lakh once your investments keep growing and your returns keep increasing. 

Based on annual returns of 12% p.a. on your investments, the following table shows: 

Returns Growth for various lump Sum investment amounts
Investment amountReturns after 1-yearReturns after 3 yearsReturns after 5 years
Rs. 1.5 lakhRs. 18,826Rs. 63,864Rs. 1.21 lakh
Rs. 2 lakhRs. 25,102Rs. 85,152Rs. 1.61 lakh
Rs. 2.5 lakhRs. 31,377Rs. 1.06 lakhRs. 2.02 lakh
Rs. 3 lakhRs. 37,653Rs. 1.28 lakhRs. 2.42 lakh

When you invest Rs.1 lakh in a lump sum, your long-term capital gains will exceed Rs.1 lakh after 5 years. It takes only three years for your long-term gains to exceed Rs. 1 lakh with a lump-sum investment of Rs. 2.5 lakh. 

When you sell holdings in your equity mutual funds every year to book long-term gains, you reinvest the proceeds into the same fund. 

Let’s look at an example to understand better how it works. On 1st February 2022, you invested Rs. 6 lakh into an equity fund and received 12% returns. This is how your investment returns and capital gains will look on 1st March 2023: 

Lump-Sum investment on 1st February 2022Rs 6 Lakh
Returns Generated12% p.a.
Investment value on 1st March 2022Rs 6.75 Lakh
LTCG on 1st March 2023Rs 75,305

Capital gains up to Rs. 1 lakh per financial year are tax-free if you redeem your investments by 1st March 2023. 

In the next step, you will need to reinvest the proceeds into the same scheme. The proceeds of the investment, i.e. 6.75 lakh on 2nd March 2023 and assuming 12% annual returns on your investment, your investment growth will look something like this by 5th March 2024. 

Initial Lump Sum investment on 2 march 2023Rs 6.75 Lakh
Return Generated12% p.a.
Investment value on 5th March 2023Rs 7.60 Lakh
LTCG on 20th March 2023Rs 84,718

Now you are redeeming your investments again. Their returns will be classified as Long Term Capital Gains because they have completed one year of investment. Due to the fact that these gains are less than the financial year’s limit of Rs. 1 lakh, you won’t have to pay any tax on them. 

Imagine you did not redeem your investment in March 2023 but instead, you do not redeem and stay invested to let your Rs. 6 lakh investment grow until March 2024. 

Initial Lump Sum investment on 1st February 2022Rs. 6 Lakh
Return12% p.a.
Investment Value on 5th March 2023Rs 7.60 lakh
Total LTCCG on 20th March 2023Rs 1.60 Lakh
Taxable LTCGRs 60,000
Capital Gains Tax ( Payable @10%)Rs 6,000

It is clear from the above that the mutual fund investments you made were not subject to capital gains tax by using tax harvesting. If you invest through SIPs, tax harvesting will also work. You must repurchase long-term capital gains units, i.e., those held for more than 12 months, and reinvest the proceeds. 

Conclusion 

Tax harvesting can reduce the tax on equity mutual fund returns (Capital Gains), which is a simple and effective strategy. A word of caution, however. Reinvesting redemption proceeds is necessary for tax harvesting to work. Capital gains tax can be avoided in the short term if you fail to reinvest. However, failure to reinvest will adversely affect your ability to reach long-term investment goals. 

As part of our financial concierge services for NRI investors, Rurash Financials offers taxation services exclusively. Nevertheless, we can connect you with a wealth custodian if you need help with tax planning.

For any guidance regarding financial instruments, Connect with our relationship managers now or write to us: invest@rurashfin.com

Also Read: Why Equity Mutual Funds are better than the National Pension Scheme in the longer run