Learn to use equity loss to reduce tax liability

Every dark cloud, they say, has a silver lining. For investors who have lost over 25% of their portfolio in the recent Indian equity market crash, it would seem rather difficult to believe this. While little can be done about the actual losses that you may have suffered, there is a way to use them to reduce your income tax liability on other gains. Let us look at one such method in this article.

A brief excursion into the relevant tax rules would be in order first. Long term capital losses can be set off only against long term capital gains. However, short term capital losses can be set off against both short term and long term capital gains. In the context of listed shares and mutual funds (both debt and equity), a period of over one year is long term, and anything less than that is considered short term. The corresponding time period for real estate and gold is three years.

For easy reference, let us put down the currently prevailing short term and long term capital gains tax rates for each of these categories below:

Asset class	Short-term capital gains tax rate	Long-term capital gains tax rate
Listed shares	15%	0%
Equity mutual funds	15%	0%
Debt mutual funds and FMPs	33.60%	Lower of 10% non-indexed or 20% indexed
Real estate	33.60%	20% indexed
Gold	33.60%	20% indexed

Of course, all these capital gains accrue when the asset is sold or transferred out.

The central theme of the idea is to use the equity market downturn to book short term capital losses. And then utilise these booked losses to set off long term or short term capital gains on gold, real estate or debt fund portfolios.

Let us look at this theme in more detail through an example. You may note that in this example, we have not taken any view on the portfolio allocation strategy per se. For instance, to determine whether you are over-weight on real estate or under-weight on equity, etc, a closer analysis of your individual portfolio is called for. Rather, we are only looking at a general strategy you can adopt to minimise tax liability within the boundaries dictated by your portfolio allocation strategy.

Assume you had a portfolio over Rs 10 lakh of investments in shares or mutual funds. Most of these investments were done late in 2007 or in early 2008. After the market crash, you find yourself looking at a portfolio value of only Rs 7 lakh today. Assume you have decided to weather this downturn and hold on to equity portfolio, either because you are willing to wait for the next up-cycle, or because your portfolio allocation suggests that. If you simply hold on to your shares, and they again rise to Rs 10 lakh in two years time, you would have squared off your losses. There would be no capital loss (or gain) that you would have. Thus, if you have any other capital gain this year � say from selling some real estate or debt mutual funds, you would incur capital gains tax on those, as per the table given above.

There is, however, a better strategy. On one of the days when the market is on a downturn, you can sell all your shares purchased over the last year. Immediately, you buy another portfolio (this can even be the same old portfolio) at the prevailing market rates. Thus, you have booked a short-term capital loss of Rs 3 lakh; and the purchase value of your current portfolio is Rs 7 lakh.

Now, you can use this capital loss to set off gains from debt mutual funds, gold or real estate in the year. In fact, you might actually want to actively book profits in real estate or gold if you believe these prices are at their peaks and are likely to come down in future. You can book just enough gains from these sales, to ensure your next capital gains tax liability over the year is zero.

To be sure, your cost value of the new equity portfolio would be only Rs 7 lakh (as against Rs 10 lakh in the earlier �hold� strategy). Thus, if you were to sell it within a year at higher value, all the losses you had shown earlier would be wiped out in the gains that would accrue here. To avoid this, it would be advisable to hold on to the new portfolio for atleast a year, after which capital gains tax is anyway zero.

The transaction cost of doing all this is likely to be minimal: 1% - 1.5% of your portfolio depending on your equity broker. By doing the sale and purchase transactions with minimal time lag, you are likely to minimise market risk of fluctuation in the interim. You can also do this if you had mutual funds instead of shares. A simple switch transaction from one fund to another would be counted as a tax event, and hence you could book your losses there. After all, this strategy is completely agnostic to market view and future movement. It is simply a way to use already accrued losses to save your tax outflow.

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