Equity investors who remained steadfastly invested through the turmoil that shook the markets once the Indian government declared lockdown last year are now sitting on handsome profit.
In case, you are one of these investors who wants to book profit, you need to plan out your long-term capital gains from the equity market as they are no longer tax-free.
What are capital gains?
Capital gains earned from the sale of shares and mutual funds after a period of one year are called long-term capital gains (LTCGs). For the gains to come under the bracket of long-term capital gains, it is necessary that they must be over and above Rs 1 lakh. Currently, LTCGs are taxed at 10%. Any LTCGs below a lakh are taxed at 0%.
There are several ways in which investors can reduce their total tax liability on long term capital gains arising from the sale of equities by taking advantage of various provisions marked out under the Income Tax Act.
As per this method, an investor can book profit in equities and not face any tax liability for it provided the gains made are under a lakh and they are reinvested. The rate at which the shares or the mutual fund units are repurchased becomes the new cost of acquisition. In order to extract the maximum benefit from this method, the investor can repeat the process every year to take advantage of the Rs 1 lakh exemption. Using this method, the taxpayer can save tax up to Rs 10,000 each year. This method can be used in respect of cumulative LTCG liability arising from equity-linked mutual funds and shares.
This method can be better explained with an example. Consider, for example, that an investor purchases 1000 shares of a company at Rs 300. After a period of three years, the price rises up to Rs 550. Let us suppose that the investor decides to sell his shares at this point in time. In this case, the sale price comes to a total of Rs 5,50,000.
The investor will be liable to pay a capital gain of Rs 15,000 after a period of three years. It can be calculated as:
Gains from sale of shares= Rs 5,50,000- Rs 3,00,000= Rs 2,50,000
Capital gains over the amount of Rs 1 lakh are taxed at 10%, which brings the LTCG to Rs 15,000. (Rs 2,50,000-Rs 1,00,000= Rs 1,50,000*10%)
By employing the method of tax harvesting, and buying and selling shares every year, the investor, in this case, can save on his tax liability of Rs 15,000.
Let us understand this in detail.
Suppose the price of the share after one year is Rs 310. If the investor sells it at this price, his total capital gains will come to Rs 10,000 (Rs 3,10,000-Rs 3,00,000). As we know already that any capital gains made under a lakh are taxed at 0%. Consequently, his total tax liability will be zero.
Suppose further that the 1000 shares are repurchased at the level of Rs 310.
In the second year, the price of the share rises to Rs 380. In this case, the capital gains comes to Rs 70,000 (Rs 3,80,000- Rs 3,10,000). Once again, the capital gains fall under a lakh and therefore exempt.
The 1000 shares are again repurchased at the level of Rs 380.
In the third year, the share price rises to 460. In this case, the capital gains comes to Rs 80,000 (Rs 4,60,000-Rs 3,80,000). Once again, the capital gains fall under a lakh and are therefore exempt.
This is how an investor can keep selling and repurchasing shares to cut back on his capital gains tax liability. However, one key aspect for equity investors to remember is that the equity market is highly volatile and investors might not be able to repurchase the shares at the price they are expecting.
Setting off and carrying forward losses:
Another manner in which an investor can save on his long-term capital gains tax liability is by setting off gains earned against losses incurred. However, one must keep in mind that short-term capital losses can be set off against long-term capital gains and short-term capital gains, whereas long-term capital losses can only be squared off against long-term capital gains.
Meanwhile, there are no restrictions, per se, in terms of squaring off of capital losses of one asset category against another. For instance, long-term capital loss from the sale of a property can be set off against long-term capital gains from investments in share or mutual funds.
Additionally, losses- be it short or long term- can be carried forward for the successive eight years, which basically means that losses incurred in this year can be squared off against gains earned in the coming year.
An important caveat for investors to remember is that their income tax returns should be filed within the due date specified under section 139 of the Income Tax Act. If the return is not duly filed, then the capital losses will lapse and the taxpayer will not be allowed to carry it forward.
Capital gains exemptions
Investors who have booked long-term capital gains from the equity market can invest the amount in 54EC bonds also popularly known as capital gains bonds. However, these bonds aren’t as popular with many financial advisors as the returns on these bonds are currently 5% and the lock-in period is five years.
One can also escape their capital gains tax liability by investing the LTCGs in a residential property. Section 54F of the Income Tax Act states that gains arising out of the sale of any assets including gold, securities or commercial property are exempt from capital gains tax liability if the gains are reinvested in buying or constructing a residential house.
While death and taxes are inevitable, it is the wise man who finds out avenues of reducing his tax burden. The overload of paying off long-term capital gains tax can be considerably reduced if one plans and anticipates his tax liability. The advice of a financial expert can also help if LTCG calculations get too complex for a layman.