Mutual funds enjoy tax advantage over most other asset types when you make capital gains. Capital gains made in equity funds, held for less than 12 months, are taxed 15.45% (including 3% education cess); if funds are held for more than 12 months, then the profits are tax free. Capital gains made in non-equity funds, if held for less than 36 months, are taxed at the income tax rate of the investor; if funds are held more than 36 months, then capital gains are taxed at 20.6% (including cess) after indexation.Most mutual fund taxation related blogs that I have come across, focus on capital gains taxation, but when you invest in market linked products like mutual funds, there are chances that you can make a loss as well. In this blog post, we will discuss tax treatment of capital losses.
What is Capital Gain or Loss?
You make a capital gain or loss only when you sell; if your fund has appreciated or depreciated in value, but you are still holding it, there is no capital gain or loss. You make a capital gain in a mutual fund scheme if the NAV of the scheme at the time of selling is more than the NAV of the scheme at the time of purchasing; you make a capital loss, if the NAV of the scheme at the time of selling is less then NAV of the scheme at the time of purchasing. Readers should note that, dividends paid by a scheme are not considered in capital gains or losses calculations for income tax purposes (there is a caveat, however, which we will discuss late).
The most important tax implication of a capital loss in a mutual fund scheme is that, it can be set off against capital gains, depending on the nature of the loss. Let us understand this with the help of an example. Let us assume that, you have bought two mutual fund schemes in the same financial year. Before the end of the financial year, you sold both the schemes. In one scheme you made a profit of Rs 50,000 and in another scheme you made a loss of Rs 10,000. In the scheme where you made a profit of Rs 50,000 you have to pay short term capital gains at the rate of 15.45%. Your capital gains tax obligation is, therefore Rs 7,725.
What about the scheme were you made a loss? Obviously there is no tax, but under Income Tax Act, you can set off the loss against the gain. You can show both the capital gain and loss in the Income from Other Source in your ITR and net off the loss from the profit. Therefore, your net short term capital gain will be Rs 40,000 (Rs 50,000 – Rs 10,000) and your tax obligation will be Rs 6,180 only. By setting off losses against gains, you are reducing your tax obligation. Readers should note that, not all capital losses can be set off against capital gains. There are tax rules governing capital loss setting off. Let us discuss each capital gain / loss case one by one.
Short Term Capital Loss in Equity Funds
Short term capital losses from equity funds can be set off against both short term capital gains from all asset types. These asset types can be another equity fund, debt funds, shares of companies, debenture, gold, real estate etc. The holding period definition for short term capital gains taxation differs from asset type to asset type. Short term capital gain / loss holding period for equity funds is 12 months, while that for debt funds is 36 months. So, if you have made a loss in an equity fund held for less than 12 months, you can set off the loss against profit made in a debt fund held for 2 years. The netting off applies against other asset types like shares, debentures, gold, real estate etc.
Short term capital losses from equity funds can also be set off against long term capital gains of all asset types, excluding equity funds and equity shares. Long term capital gains in equity funds and shares are tax free, so the question of setting off losses against it does not rise. However, if you have long term capital gains from debt funds or asset types, you can set off short term capital losses from equity funds against the long term capital gains. When setting off short term capital losses in equity funds against long term capital gains of other asset types, do not subtract the capital loss from the gain because the tax rates are different for different asset types;calculate the tax payable on long term capital gains and the tax credit due to the capital loss. The difference between the tax payable and the tax credit is your tax obligation.
Long Term Capital Loss in Equity Funds
Long term capital gains from equity funds are tax free and therefore, you cannot claim any tax benefit for long term capital loss in equity funds. In other words, long term capital loss in equity funds cannot be set off against either short term or long term capital gains of any asset.
Short Term Capital Loss in Debt Funds
Short term capital losses from debt funds can be set off against both short term capital gains of all asset types. These asset types can be equity fund, debt funds, shares of companies, debenture, gold, real estate etc. So you if have made a loss in an debt fund held for less than 36 months, you can set off the loss against profit made in a equity fund held for less than a year. Short term capital losses from equity funds can also be set off against long term capital gains of all asset types, excluding equity funds and equity shares.
Long Term Capital Loss in Debt Funds
Long term capital losses from debt funds can be set off against long term capital gains of all asset types, excluding equity funds and equity shares. Suppose you have made a long term capital loss of Rs 20,000 in a debt fund and a long term capital gains of Rs 50,000 in a Gold ETF. Let us assume that long term capital gains tax (@ 20.6% after indexation) for the Gold ETF is Rs 6,000. Further assume that tax credit for the debt fund loss is Rs 1,000. Therefore, your tax obligation will be Rs 5,000 only.
Long term capital losses from debt funds cannot be set off against short term capital gains. For example, if you have made Rs 20,000 long term capital loss in a debt fund and Rs 20,000 short term capital gain in an equity fund. You will not be able to set off the loss and will have to pay 15.45% short term capital gains tax on the equity funds profit and your tax obligation will be Rs 3,090.
Loss Carry Forward
If your capital gains are not able to fully absorb the loss (in other words, loss is more than profit), you can carry-forward the loss to the next financial year and set off against future profits. Such carry-forward can be done for 8 years maximum. Please recall, however, that long term capital loss from equity funds cannot be carried forward because it cannot be set off against short term or long term profits.
Capital Loss after receiving dividends
We had earlier said that, capital gains / losses are calculated by subtracting NAV on purchase date from NAV on redemption (sale) date. Some investors buy equity mutual fund units based on information from their sources or market rumours that the Asset Management Company will declare a large dividend shortly. Equity mutual fund dividends are tax free as per Income Tax Act. Since, the dividends are declared from the assets of the scheme the NAV (price) falls after dividends are paid. The investor then redeems (sells) the units of the fund with a view to claim short capital lossin his IT return. This practice is known as dividend stripping. To prevent tax avoidance through dividend stripping, capital loss set off is not allowed under Income Tax Act, if investment was made within 3 months of dividend record date or redemption was made within 9 months of the dividend record date.
Nobody wants to make a loss in an investment. However, Income Tax Act allows you to use a loss to reduce your tax obligation. Investors should note that, capital loss cannot be set off against income from other heads. In this post, we have discussed how you can use losses to reduce your tax obligation for profits from other investments, within the rules of Income Tax Act. If you have made a loss, you can set off against profit made in the same financial year or carry forward the loss to the next year.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.