Mangal Dutt Sharma does not get overly perturbed when his stocks take a beating. "If possible, I book short-term losses and adjust them against other capital gains," says the Faridabad-based retired PSU manager. In 2008, when the capital markets were crumbling, Sharma booked short-term losses of up to Rs 1 lakh. Over the past six years, he has adjusted those losses against short-term capital gains from stocks and mutual funds. It's a simple strategy that smart taxpayers like Sharma use to cut their capital gains tax.
Certain losses from the sale of capital assets can be adjusted against gains from other assets. If the entire loss cannot be adjusted in one year, the taxpayer can carry forward the balance for up to eight financial years. The average taxpayer, however, is blissfully unaware of the provisions relating to capital losses.
Meet Abhay Kukreja, an Agra-based sales manager in an FMCG company, who also dabbles in stocks. Over the past 6-7 years, Kukreja's luck with stocks has been a rollercoaster ride. Though he diligently paid 15 per cent tax on the short-term gains from stocks during good years, he quietly absorbed the losses incurred during the down years. What's more, he has also paid tax on other capital gains from FMPs and gold funds during the past 3-4 years.
"If only I had known that the losses from stocks could be carried forward to subsequent years, I would have saved a lot of tax," he says.
Our cover story this week is a primer on how you can adjust, reduce and avoid capital gains tax. The rate of tax on capital gains depends on the nature of the asset and the holding period (see graphic).
How to adjust, reduce & avoid capital gains tax
In the first section, we look at how an investor can adjust his gains against losses. The effective rate of capital gains tax also depends on the inflation during the holding period. In the second section, we examine how inflation indexation can help cut the capital gains tax. It is a useful strategy that can reduce the effective tax to almost zero during times of high inflation. Finally, we look at the investment options available for saving capital gains tax. Under Section 54, if the capital gains are reinvested in certain specified options or used for buying residential property, the tax can be avoided.
The story is well-timed because the financial year is drawing to a close. Investors have a two-week window to plan their capital gains tax. Some may book losses in stocks before 31 March. Others may invest in FMPs for double indexation. Whatever your situation is, use this opportunity to minimise your tax and maximise returns.
ADJUST LOSSES AGAINST GAINS OR CARRY FORWARD
Certain capital losses can be adjusted against other gains.
March is a busy month for taxpayers — not only the lazy ones who didn't do their tax planning through the year, but also savvy investors who want to book losses before the end of the financial year.
Retail investors generally hate to book losses, but smart investors do it regularly to reduce their tax. If you, too, have suffered a loss in a stock bought less than a year ago, this could be a good time to sell it and book a loss. You can always buy back the stock later if you are convinced that it is a good long-term bet.
However, make sure this is not an intraday transaction. You must sell the loss-making shares and give delivery before buying it back. Intra-day trading does not get the same benefit. "These are speculative activities, not delivery-based. The gains will be treated as business income," says Minal Agarwal Jain, managing partner, Mahesh K Agarwal & Company.
Keep an eye on the calendar when you book short-term losses on stocks. If it has been more than a year since you bought the stock, you will not be able to adjust the loss. Only short-term losses (made within a year of the purchase) from stocks can be set off against gains. Long-term losses are not eligible for this tax benefit.
Experts warn that one should not go overboard with this strategy of booking losses and buying back the security. "If you conduct a large number of short-term transactions, the tax department may treat it as business activity and tax you accordingly," says Nikhil Bhatia, executive director, PwC India. You may have to pay tax according to your slab even on long-term capital gains from stocks.
How to adjust, reduce & avoid capital gains tax
There are some other things that you should keep in mind. Long-term capital losses can be set off only against long-term capital gains. If you bought a property for Rs 40 lakh in March 2008 and sold it five years later for Rs 60 lakh in April 2013, you would actually incur a loss. This is because the indexed cost of the property would be Rs 64.5 lakh. The Rs 4.5 lakh capital loss can be adjusted only against other long-term gains.
Short-term gains cannot be set off against this loss. However, short-term capital losses can be set off against short-term as well as long-term capital gains. This spawns a whole lot of tax arbitrage opportunities. If an investor earns more than Rs 10 lakh a year, any short-term capital gains from non-equity investments will attract a tax of 30 per cent. He can book short-term capital losses from equities and use them to reduce the tax on capital gains from FMPs, gold funds and debt funds. There is a great opportunity here for small businessmen.
Capital losses cannot be set off against any other head of income. However, losses from business or profession can be set off against the short-term or long-term capital gains. If one incurs a loss in business in a certain year, he can book capital gains in that year and adjust them against his business losses. "Business losses can't be set off against income from salary, but they can be set off against capital gains," says Vineet Agarwal, director, KPMG India.
Allow us to slip in a caveat here. One can only adjust business losses booked in a certain year against capital gains. Business losses carried forward from previous years cannot be adjusted in this manner. "Business losses that are carried forward can only be set off against gains from business in future years," says Manish Shah, partner, S K Parekh & Co.
The best part is the provision to carry forward the loss. If the losses cannot be adjusted against the gains, don't worry. You can carry forward the loss for up to eight financial years. "The important thing is that one can carry forward the losses only if one files his tax return within the deadline," says Divya Baweja, senior director, Deloitte in India. That's a good reason to file your tax return.
USE INFLATION TO REDUCE THE TAX LIABILITY
Indexation factors in the inflation during the investment period and accordingly adjusts the cost of an asset.
From the finance minister to the humble peon in his office, everyone is worried about high inflation. Well, almost everyone. For some investors, high inflation can also be a boon that brings down their tax on long-term capital gains. Long-term capital gains are eligible for the indexation benefit, which can reduce the tax to almost nil (see box).
How to adjust, reduce & avoid capital gains tax Indexation is a useful tool for investors like Pankaj Gulati (see picture). The Delhi-based engineer is socking away money in debt funds for his retirement. "With the current high inflation, the capital gains from debt-oriented mutual funds after inflation indexation are virtually tax-free," he says.
How to adjust, reduce & avoid capital gains tax
We calculated the effective tax rate on an investment of Rs 1 lakh in a debt fund in 2003-4. Assuming an annual return of 9 per cent on the investment and an annual withdrawal of Rs 9,000 after one year, the average effective tax rate after indexation has been less than 3 per cent (see graphic) in the past 10 years. How to adjust, reduce & avoid capital gains tax
How can the tax be so low on systematic withdrawal plans (SWPs)? First, when the investor withdraws from his investment, a large portion of the redemption amount is the principal. The gains constitute only a small portion in the initial years. In the first year, for instance, less than 9 per cent of the redeemed amount is the gain. What's more, indexation pushes up the price of acquisition and brings down the capital gains even further to barely 1 per cent. Though the capital gains component and tax liability will keep on increasing over the years under the SWP, it will remain competitive compared to other fixed income options such as bank FDs.
The treatment of income as capital gains is what helps debt funds score over fixed deposits. The income from fixed deposits is fully taxable as income of the investor and taxed at the normal rate. If he is in the 30 per cent tax bracket (taxable income of more than Rs 10 lakh a year), the post-tax yield on a 9 per cent fixed deposit is only 6.3 per cent.
As our calculation shows, the post-tax yield from the debt fund will be close to 8.74 per cent if the investor claims the indexation benefit. If he doesn't go for indexation and pays a flat 10 per cent tax, the yield will be lower at 8.1 per cent. The indexation approach is particularly useful if you buy at the fag end of the financial year (see box).
If Rs 1 lakh was invested in March 2009 in a debt fund that gave 9 per cent annualised returns, the investment would be worth Rs 1.53 lakh today, but the indexed cost comes to Rs 1.61 lakh. So you book a loss of Rs 8,000 when you redeem the investment. If you wait for another two weeks, and redeem the investment in April, it will be more beneficial.
The CII for the financial year 2014-15 will only be announced later in the year. If we assume it to be 9 per cent higher at 1,023, the indexed cost will be higher at Rs 1.75 lakh and you will be able to book a loss of almost Rs 22,000. This is why in March, the market is flooded with FMPs that extend into the first few days of financial years in the future.
Right now, there are several FMPs available (see table). Many of them are for 13 months, which will get double indexation benefits. Double indexation can be availed of if the holding period is across three financial years. If you buy a 380-day FMP right now, it will mature in April 2015. Even with a reasonable indexation benefit of 8 per cent per year, the double indexation will take the indexed cost up by 16.64 per cent, much higher than the potential return from the FMP.
How to adjust, reduce & avoid capital gains tax
The gains will not only be tax-free but you can even book a loss. "You can set off this loss against other long-term capital gains," says Sandeep Shanbhag, director of Wonderland Consultants.
Do the math before you invest. The 1,825-day FMP from UTI, for instance, will mature in 2019-20 and only give you indexation benefit of five years. However, if you take the 1,832-day FMP from Reliance, which will mature in 2020-21, you will get an extra year's benefit. Also keep in mind that not all investments are eligible for the indexation benefit. It is specifically denied to any instrument that mentions an interest rate.
So, even though debentures or bonds are listed and traded in the market and the profit from their sale is treated as capital gains, there is no indexation benefit available. This bar is applicable even for the bonds where the interest is compounded over the years. "The rule is simple. Indexation benefit is not allowed if the rate of interest per annum is mentioned anywhere," says Viren Pandya, a Mumbai-based chartered accountant. This rule is designed to stop investors from getting multiple benefits.
Otherwise, a tax-free bond will give tax-free interest every year and also allow the investor to book a huge long-term capital loss after 10-15 years. It is not clear how the new breed of inflation-indexed bonds, where only a small real interest is paid out every year and the inflation part is added back to the principal, will be treated.
"We need to wait and watch as there is no clarity on the issue," says Shanbhag.
INVEST GAINS IN SPECIFIED AVENUES TO SAVE TAX
Using capital gains to buy a house or invest in certain bonds gets tax exemption.
Just like Section 80C investments bring down your income tax, certain investments can reduce your capital gains tax liability. This is especially useful in case of big-ticket gains from selling a property.
Under Section 54, if the capital gains are reinvested to buy another house, they will not be taxed. However, real estate is not a very liquid investment and it is very difficult to perfectly time your sale and subsequent purchase. This is why the tax rules allow the investor a window of three years for effecting both transactions. The new property can be purchased one year before and up to two years after the sale of the old one. If the proceeds are used to construct a new house, the time allowed is three years.
Section 54F allows one to set off capital gains from other investments as well. However, the rules here are more stringent. First, the investor should not own more than one house. "If he has more than one residential property at the time of transfer of capital assets, the investor can't get the benefit under Section 54F," says Shah.
Second, while only the capital gains are required to be invested in the new property under Section 54, the entire sales proceeds must be used when you are seeking tax exemption under Section 54F. You can combine all long-term capital gains (from jewellery, house, land, mutual funds, etc) to buy a new residential house under this section. However, under both sections, you have to hold the new residential house for at least three years, otherwise the tax benefit will be reversed.
Often, there is a long gap between the time an investor sells an asset and when he buys another one. If the due date for filing taxes is nearing, one should park the funds in the capital gains account scheme (see box) and withdraw when the asset is to be acquired. However, if he fails to reinvest the proceeds in the asset within the deadline, the unutilised capital gains will be taxed.
One can also avoid paying capital gains tax by investing in special bonds issued by the NHAI or REC under Section 54EC. The capital gains have to be invested in these bonds within 6 months of the transaction. However, only Rs 50 lakh can be invested under this section in a financial year. Here again, the minimum holding period of the bonds is three years. These bonds are useful if the price of the new house is less than the capital gains made from the old property.