How to use losses to reduce tax

Are losses good ? Do they have any benefit ?

When you make a loss , do you feel it has nothing to provide or not at all beneficial .The answer is NO! , losses are bad, but our tax laws gives us a way to utilize them in such a way that we can reduce our tax liabilities . Lets see how , don’t worry , we will start from scratch and will explain in detail so that everyone can understand .

Let us talk about capital gains in detail today and let us understand how should we utilize it to minimize our tax liability. Things we will discuss would be stocks , mutual funds , Gold , Debt funds , Real Estate etc .

Understanding Terms and Rules

Capital Gains and Loss : Any profit or loss aris from the sale of capital assets is capital gain or loss . Capital Assets Include Shares , Mutual funds , Real Estate , GOLD etc .

Short Term Capital Loss and Profit : STCL for Equity (shares and mutual funds) is when you sell them at loss before 1 yr , for Real estate , GOLD its 3 yrs .

Long Term Capital Loss and Profit : LTCG for Equity is when you sell it after 1yr , for Real estate , GOLD its 3 yrs .

Following is the chart showing the tax treatment and time frame for short term for each asset class. Click on the chart to enlarge it .

General and Carry forward Rules :

• Short-term capital loss can be set off against any capital gain (Long-term or Short-term)
• Long-term capital loss can be set off only against long-term capital gain.
• A long-term capital loss will have no value in a case where the long-term capital gain is exempt from tax . For example, In case of shares or mutual funds after 1 yr , LTCG is exempt from tax , so If you hold a share for more than 1 year and then take a loss , That LTCL will have no benefit . This loss cannot be set off against any other income.
  
• A capital loss can be carried forward for next 8 years .

How can you utilize the losses ?

As we know that capital losses can be offset with capital gains , we can utilize this advantage to reduce the tax liability .

The main idea is to create losses to offset any profits . There may be the cases where there is a investment on which you are loosing , but still you have not booked the loss , but you can book it and use this loss to offset a profit on which you may have to pay the tax .

Let us see some examples

Example 1 :

Ajay had invested Rs 5 lac in GOLD in 2005 and currently in 2009 he sold it for Rs 10 Lacs , Now he made a profit of 5 lacs and it will be considered as a LTCG , as its after 3 yrs . and it will be taxed at 20% indexed (If you dont know what is indexed , just forget it , dont worry ) . The tax would be around Rs 1 lacs .

Now Ajay also had invested Rs 10 Lacs in Unitech Shares in Apr 2008 . His investment has come down to Rs 4 lacs now . But he thinks that it will go up and he wants to keep it and not sell .

Good !! , I appreciate his belief that it will go up again . But what is stopping him from selling it today and then again buying it next day .

What will happen if he does that ? If he sells his shares and takes a loss of Rs 6 lacs , He now has made a STCL of Rs 6 lacs and law says that he is allowed to offset it with any STCG or STCL . So now he can offset his 5 lacs profit with this 6 lacs loss and hence , he can save his tax of that 1 lac which he had to pay , also he can carry forward a loss of remaining 1 lac which was not offset .

He can again buy his favorite Unitech share the next day . The only loss he will make is the brokerage charges and any fluctuations which may occur in prices , which will not be much , may be it has gone down and he can buy them later at better prices .

So the point is to generate the loss by selling a loosing investment and again buying it back in some days . This will help you cook up the looses which then you can offset with existing profits and hence reduce your tax liabilities .

Let us also see one more example

Example 2

Robert had invested 5 lacs in mutual funds in early 2008 or end of 2007 and currently has a good loss of 2.5 lacs (1 yr is still not complete) . This is currently every one state , most of the people have burnt their fingers and made huge losses .

Now he is sad that he made losses , He also had bought some shares before some months and made a profit of 50k . Let us also assume that next year his mutual fund will rise to 4 lacs from current 2.5 lacs , which he sells next year .

Now he has 2 choices to make , let us see 2 cases .

Case 1 : He does not book the loss and holds it .

In this case , he will have to pay profit of 15% STCG on his profit of 50k , and next year he will have his current investment at 4 lacs . When he sells it , it will be a loss of lac which will be LTGL (because he had hold it for more than 1 yr) .

Case 2 : He books the loss of 2.5 lacs and then again buys it back the same day or next day .

In this case , he has made a STCL of 2.5 lacs (bought at 5 and sold at 2.5) , Now he can offset his 50k profit with this loss . Then he would not have to pay the tax and he can then carry his loss of 2 lacs carry forward .

Next year , he sells his mutual funds for 4 lacs and makes a STCG of 1.5 lacs (because he has re-bought this mutual fund and 1 yr is still not complete) ..But he can offset this profit of 1.5 lacs with the carried forward loss of 2 lacs , and still carry another 50k worth of loss forward .

So whats the advantage of case 2 ?

The advantage is that you can save tax on the existing profit and also generate STCL which you can take forward and save tax on future profits .

There are many people who make losses and dont bother to show it in there returns , if they dont show it in returns then they will not be able to use it for offsetting purpose in future .Note , The way i have shown the examples have there own benefit and problems , Its you who have to decide what you want and how to utilize the tax rules to your advantage .

Its smart use of knowledge , not cheating

I wish you have got some knowledge out of this article , please put your comments/corrections/suggestions so that we can do more discussion .

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