Harvesting Tax Gains

Tax gain harvesting, as opposed to tax loss harvesting, is the process of turning unrealised long-term capital gains into realised capital gains at a specific time for tax purposes. The article highlights the details of such a process and points out the benefits 



Continuing the momentum of the year 2017, the year 2018 started on a very good note with the market touching its all-time high of that period in the month of January. Nevertheless, with the start of February 2018 the market started showing signs of nervousness and the equity market represented by Nifty and Sensex, after touching the 11,000 and 36,000 marks respectively, saw a fall of 10 per cent in the next two months. One of the reasons attributed to such a fall was the re-introduction of Long Term Capital Gains (LTCG) Tax in the Union Budget 2018-19.

At that time Arun Jaitley, then the finance minister, made a proposal to impose a 10 per cent LTCG Tax on equity gains over and above Rs 1 lakh in any financial year. All the LTCG made up till January 31, 2018 were grandfathered, which means that gains made after that date would be taxed. Whatever the reason for the fall of the equity market at that time, for the next two financial years it did not create as much of an impact for equity investors. This is because for the next two and half years, on an average, the equity market did not make substantial profit that would warrant profit booking and payment of LTCG Tax.

The graph below shows the movement of different equity indices since the start of 2018. What is clearly visible is that though the large-cap equity index represented by Nifty 100 yielded positive returns for a brief period in September 2018 and in January 2020 and February of 2020, it was not substantial. Moreover, the broader market represented by mid-cap and small-cap indices failed to generate returns since 2018. It is only in the last couple of months that mid-cap has been able to generate some returns. This is also highlighted in the table below that shows that average returns generated by different categories of equity-dedicated funds after January 2018, which were not great and there was no opportunity for investors to book profit. On an average, between February 1, 2018 and end of March 2019, we saw equity-dedicated mutual funds generate negative returns. The exception was the IT sector that generated returns in double digits. The situation worsened in 2020 when not a single category generated positive return and the average return for the equity-dedicated funds between February 2018 and end of March 2020 was at around negative 12 per cent.

Now, it is the first time after the re-introduction of LTCG after a gap of 14 years that investors will get an opportunity to book profit and indulge in tax gain harvesting. Many of us might have heard of tax loss harvesting; however, tax gain harvesting is a new term and its meaning needs to be understood.

Tax Gain Harvesting
Tax loss harvesting is quite prevalent and is being used by smart investors around the world. Tax gain harvesting, as opposed to tax loss harvesting, is the process of turning unrealised long-term capital gains into realised capital gains at a specific time for tax purposes. It may sound counter-intuitive to book profit to save on tax as we are used to consider delaying the realisation of capital gains to defer tax. Nevertheless, from FY19, after the introduction of LTCG Tax, it was possible take advantage of tax gain harvesting to increase your post-tax returns.

However, as explained in the earlier paragraphs, investors could not use it as FY19 and FY20 did not provide much opportunity to harvest tax gain. However, the spectacular rise in the equity indices over the past 10 months, where the bellwether index itself has doubled, has created many opportunities for investors to use tax gain harvesting to optimise their post-tax returns. So what should be they doing with their gains? The simple answer is to book profit and invest once again in the same fund or any other fund in case your financial planning objective requires you to do so. This helps an investor in two ways. First, you can claim benefit of Rs 1 lakh of profit every year, which otherwise would expire and second, once you reinvest, it increases your cost of acquisition that reduces the future capital gain and any tax on it. We will explain the entire process and the logic behind it through these hypothetical cases. 

Case I: No Tax Gain Harvesting
In this case, you pay tax when you sell your units. We assume you are an investor who does not believe in active management of your investments and tax planning. You will sell your mutual fund units only if your financial plan requires you to do so or other reasons such as bad performance of your funds. In such a case you contribute a little more to the government kitty in the form of tax. The following table shows how much tax you will pay in five years for different SIP amounts in case you remain invested for five years and sell after five years.

Note: Cells highlighted in blue represent a situation where you need to pay tax if you book profit.

While preparing the above table we have assumed that your investment grows at a rate of 10 per cent every year. Therefore, if you are investing Rs 5,000 every month, your total investment in five years would be Rs 3,00,000 (5,000 x 12 x 5). This investment will generate gain of Rs 85,858 in five years. If you sell it, you do not require paying tax as it is lower than Rs 1 lakh. Nonetheless, if either your investment amount increases or the rate of return increases, you need to pay tax.

For example, in the alongside table, in case your investment amount is Rs 50,000 every month, your gain will exceed Rs 1 lakh in the second year only. Nevertheless, if you sell your investments at the end of the fifth year, your accumulated gain would be Rs 8,58,587. For this profit you need to pay tax of Rs 75,858 at a rate of 10 per cent over and above Rs 1 lakh.

Case II: Limited Tax Gain Harvesting 
In this case you sell your units whenever your gain exceeds Rs 1 lakh. We assume that you book profit on your investments only if your profit exceeds Rs 1 lakh. In the first case we abstained ourselves from booking profit till the fifth year when you sell your entire units. Then we paid tax based on realised gains after five years.

In this case, you book profit as soon as your net profit exceeds Rs 1 lakh. In the above table you can see your gain exceeds Rs 1 lakh in the second year itself if your SIP amount is Rs 50,000. Hence, you will reset your portfolio in the second year when your accumulated gain is Rs 1,27,256.34. You will sell your entire portfolio and purchase it again. This will help you to book profit and reset your portfolio with higher cost of acquisition. Similarly, in case your SIP is Rs 30,000 every month, you need to reset your portfolio in the third year. If you continue to do so, your tax liability will be reduced by Rs 30,365 in five years in case of SIP of Rs 50,000. The table below illustrates the entire process and the amount of tax you need to pay in five years.

Therefore, following this strategy you could save tax of little more than 1 per cent of your total investment in five years

Case III: Full Tax Gain Harvesting
Here, you book profit every year and reset your portfolio irrespective of how much your portfolio has gained. This is the most actively managed tax harvesting strategy. You reset your portfolio every year by selling your investments and then re-investing it irrespective of the gain you have pocketed. You will not wait until your investment gain has reached Rs 1 lakh. Our analysis shows that this gives you the best post-tax return. The reason is that it helps you to take advantage of capital gain exemption every year. Since this exemption is not carried forward and lapses every year, it’s better to take advantage of this every year. The following table illustrates how this gain works out to be .

In the above table the gain changes from the previous table every year expect for the first year because last year’s sales price becomes the purchase price of this year and hence every year’s gain is lesser than the earlier two cases. This leads to lower tax incidence in this case. The following table gives you a summary of the tax that you need to pay in each of the above cases.

Steps for Tax Gain Harvesting

✓You identify investments that have completed one year and are in profit.

✓You book profit in the fund and repurchase it again.

✓Use this profit to take advantage of Rs 1 lakh exemption provided in case of LTCG Tax.

✓You can also purchase different funds from the sale proceeds.

Getting Your Hands Dirty
Tax gain harvesting would have been very easy if you would have made lump sum investment at the start of the year. The complexity seeps in when you take the SIP route for investment where you make equal investments every month. This is because you need to track the record of NAV at which you invest every month. The reason being that if you sell your MF units before one year you will have to pay a Short Term Capital Gain (STCG) Tax , if any, and hence you will have to wait for at least one year before you could sell your MF units to avail Long Term Capital Gain Tax exemption. MF investment assumes redemption of units on FIFO basis i.e. first in, first out. Hence the units purchased first are redeemed first and you have to pay the appropriate tax on any profit, whether STCG Tax or LTCG Tax.

So, for an SIP that ran from January to December, if you sell some of the units, then you are taxed for your January units first and your December units the last. For example, consider that you have invested in a fund at a NAV of Rs 10 in the month of January and Rs 12 in the month of February and so on for the entire year. In January next year when you sell your MF units, the tax calculation will first take into account the NAV of January and the number of units purchased during January. Therefore, this method will require you to keep accurate cost basis information for all of your MF unit purchases.

However, it’s worth the trouble if you want to save tax. Higher the investment amount, longer the investment horizon and higher will be tax savings. We tried active tax gain harvesting with one of the multi-cap funds. In the last 10 years we could save a total 13 per cent, which means around 1 per cent every year. There were some years when there was no gain on investment as the market and funds generated negative return. This strategy will help to post better returns during an ascending market.

Conclusion
Our analysis shows that tax gain harvesting is believed to have a significant positive impact on investment returns over the long run. What we have followed is a simple investment strategy. If you also include tax loss harvesting along with tax gain harvesting, the post-tax returns will definitely be superior to the simple buy, hold and sell strategy. It will work best if you have lower number of SIPs, say, a maximum seven, as after that it becomes tedious to keep track of NAVs manually.