(Complicated) tactic to harvest capital losses

[reeseb]

I had commented in another thread about doing some complicated stuff to help with harvesting of capital losses. This short post should help clarify my proposal.

Context: 1. Equity is volatile and can have reasonably deep drawdowns. A fall of 20% from market highs is possible and in fact should be expected. 2. Since LTCG in equity is taxable, LTCL can be used to set off gains and can also be carried forward. STCL can always be set off against both STCG and LTCG.

Assumption (a big one). Mutual funds in statement of account form are allotted in folios. The formal portals (RTAs, MFU, etc. as well as the AMCs) ask you to choose a folio when you want to redeem your units. The FIFO order for redemption is applied only within the folio. Personally I have seen this happen. CAMS gives average age of your investments and this changes within the folio.

Tactic:

• If you are dealing with a handful of mutual funds, create folios periodically. An useful thing would be to create a folio every financial year.
• During that period, buy mutual fund units in that folio. After the period is over, create another folio.
• After a few years, you would have a set of folios with different average age, and hopefully different unrealized capital gains and losses.

Scenario: Thanks to /u/ hellO_india for this list. I have modified it to include debt funds too.

year 1: good market, 10 units purchased each in equity and debt

year 2: good market, 10 units purchased

year 3: good market, 10 units purchased

year 4: bad market, 10 units purchased

year 5: bad market, 10 units purchased

Now in year 5, (or early in year 6), year 5 units would be in loss, year 4 units also would be in loss. Some would be LTCL and some would be STCL.

Now calculate the unrealized capital gains from year1,2, etc. Calculate unrealized capital losses from year 4 and 5.

a) Simple tactic - Sell only the units in loss, book the loss and carry it forward. You can use it in later years

b) More complicated - Sell enough units from both lots to make the sum zero. You can also look to use up the 1 lac per year exemption on LTCG. Of course you don't want to sell off everything

Create yet another folio and purchase enough units for the redemption amount. (Of course if you wanted to switch funds, you can do that too.)

Net, net - you have almost all the previous money (except for a very small STT) invested. You have done some accounting to either net off gains and losses and/or carry forward losses for future netting off. Of course, your investments are at a lower overall purchase price.

Please note that loss can be set off against gain from *any* capital asset. Some assets have indexation and some don't. Doing these monkey tricks helps you to possibly gain overall. If you had all the units in the same folio, there is no way for you to force a particular lot to be sold.

If you are dealing with only equity mutual funds, these tactics won't help much - since you would be lowering your acquisition cost. Booking 1 lac of LTCG every year is still helpful.

(For a reasonably simple and accurate description, please look up this blog post: https://www.relakhs.com/set-off-carry-forward-capital-losses/BTW, this and basunivesh.com seem to have a competition on the number of topical blog posts!)

 

[jesuslovesme1973]

@reeseb Found this at AMFI

https://www.amfiindia.com/Themes/Theme1/downloads/sai/sai44.pdf

De-duplication of Folios / Consolidation:In case an investor holds investments in multiple folios under the Fund, the AMC has the right to consolidate all the folios belonging to the same investor into one folio (target folio). All the information as available in the target folio including bank account details will be used for further processing. Accordingly, redemptions / switch-out requests made subsequent to the consolidation shall be processed based on the First-in-First-out (FIFO) methodology as if units were held in a single folio.

Which may essentially lay waste all the work done.

 

[graceoverfear]

@jesuslovesme1973 Don't ask me how I know this. Before consolidating folios, any AMC will normally send a letter to the investor asking if he/she has no objection to that. If you say you object, they won't. But suppose an AMC does consolidate without permission, if an investor raises a ruckus challenging that, they won't.

 

[cchc]

@reeseb @trentak something you can add to Kuvera?

 

[trentak]

@cchc Yeah, build in capital loss harvesting to maximize LTCG harvesting over multiple years. Makes sense.

 

[solomonhezekiah]

@trentak I was just thinking of the theory recently and started searching of anyone else has done this. There will always be one

I think splitting the investments per FY in different folios is really a nice idea. It definitely is more advanced topic for an average person. But worth the efforts.

In fact, i had just talked to a support person from kuvera with a feedback to make these a little easier i. e. provide a feature of adfing a tag to the folio numbers within the platform. In my case, i was planning to tag the folios with the FY so that it will be easier to identify the folios during investment and redemption.

I don't know if it reaches the decision maker.

Tagging @trentak anyway

 

[rgw00]

@cchc its a paid service in Kuvera

 

[cchc]

@rgw00 No, not this specifically.

The ones you are referring to are trade smart and ltcg harvesting.

 

[jesuslovesme1973]

@reeseb Does the Income Tax Laws explicitly state that the FIFO rule will be applied only within a folio. Or does it say that it will apply to all your holdings in a particular stock/fund?

 

[reeseb]

@jesuslovesme1973 I am not a tax expert and would defer to others on the specifics, if any, in the IT rules.

This is what I see when I sell using CAMS or MFU - the units from the selected folio are sold in FIFO order. Other folios are untouched.

 

[jesuslovesme1973]

@reeseb

• if the tax law is that "all your holdings of a particular stock or fund across folios, across demat accounts are treated as one single holding", then your scheme is not necessary at all since no TDS is deducted for capital gains by the broker or AMC. You can do the calculations assuming everything is one single basket & pay the appropriate capital gains while filing your returns.
• If the tax law is that it's FIFO within a folio or within a demat account, then your whole scheme is an illegal tax evasion strategy. All your scheme does is make it more difficult for the tax authorities to detect.

So in my opinion, if it's either of these 2, either your scheme is not necessary at all or it's a way to cheat the tax authorities. Hence my question.

 

[crixus123]

@jesuslovesme1973 MF withdrawals are FIFO within folios, and it's been that way since inception.

Also note, tax harvesting (especially in Debt) with multiple folios have been around much longer. This isn't a knee-jerk reaction to LTCG taxes in equity.

This has been around for a long time, and not just in India.

IT law has no provision for whether withdrawal should be FIFO or not - their regulations only deal with how to tax realized gains.

AMFI and SEBI might have it, but it makes sense to apply this uniformly for every investor - that older units are redeemed first.

If I've folio A and folio B, then if I withdraw from folio A which has smaller gains (more recent investments), it doesn't mean I'm cheating the Govt. for not withdrawing from folio B.

For something to be illegal, it has to be explicitly stated in some form of regulation. Fortunately, no such provision exists.

No such rule can be imposed either, that one investor must have no more than one folio per fund house.

Because folios capture lot more info than just your PAN details - residence status, holding patterns, other holders etc.

Such loopholes exist in other aspects as well. For instance, you can avoid lot of NRI compliance by investing through your parents' name who aren't NRI.

Or even normally, if your mom or MIL are housewives without regular source of income, one can invest in their names to save some taxes.

The only way to plug such loopholes would be that Govt. make money transfer between children and parents taxable - but you can see why a democratic Govt. would never do that.

As such, loopholes exist in various places, and it's not always possible to plug all these loopholes without sacrificing something bigger. But that doesn't mean taking advantage of such loopholes is illegal or of criminal nature.

 

[jesuslovesme1973]

@crixus123

MF withdrawals are FIFO within folios, and it's been that way since inception.

Is this as per tax laws or as per how AMCs operate? That is my question.

Also note, tax harvesting (especially in Debt) with multiple folios have been around much longer. This isn't a knee-jerk reaction to LTCG taxes in equity.

I am not questioning tax harvesting at all. You are missing my point.

IT law has no provision for whether withdrawal should be FIFO or not - their regulations only deal with how to tax realized gains.

And how do their regulations say you should tax realized gains? That's the question.

For something to be illegal, it has to be explicitly stated in some form of regulation.

If it's legal - do it in your returns. i.e just have one folio. Do multiple transactions on the same folio & do your tax harvesting calculations while filing the returns on paper. How does having multiple folios help?

 

[crixus123]

@jesuslovesme1973

Is this as per tax laws or as per how AMCs operate? That is my question.

Tax law has no say on which order MF units are to be withdrawn, that's decided by AMFI and SEBI. Tax law can only give direction on how gains are to be computed, and how to calculate tax on that.

You've three options:

• oldest units redeemed first
• youngest units redeemed first
• let the investor decide which units to redeem when

Second one would be highly unfair, as one could come under STCG and get no benefit for long term investments.

Third one can be difficult to implement, and most likely not possible.

That leaves first option as the only viable option that can be uniformly implemented across all RTAs and AMCs.

And how do their regulations say you should tax realized gains? That's the question.

Realized gains are computed as sale price minus cost of acquisition of those units. In some special cases, they might allow indexing the purchase price or replace the purchase price with price on some other date (2018 budget did this).

Taxation in realized gains depend on holding periods of sold units, and type of asset.

It's up to the investor on choosing method and date of realization.

If it's legal - do it in your returns. i.e just have one folio. Do multiple transactions on the same folio & do your tax harvesting calculations while filing the returns on paper. How does having multiple folios help?

Having multiple folio lets an investor sandbox the redemption transactions.

As in, if you've folio A and folio B, where you've lot of amount parked in folio A for long term; and folio B has some small amounts with high turnover (frequent buy and sell); then as an investor, I've purchased units in folio B more recently.

So I can realize gains from folio B. As an investor I'm getting same amount in hand, but folio A might have had higher gains if I had transacted on that.

Say, folio A and B both have same liquid fund. In folio A, there's 10L invested, 2 years ago. In folio B, there's 1L invested, 1 week ago. Now, I need to take out 25k.

In folio B, since it's been there for a week, 25k has come from 24,997 INR => 3 INR gain.

In folio A, 25k comes from 20k (long term appreciation) => 5k gain.

Here, keeping frequent transactions sandboxed in folio B reduces tax liability - because realized gains and hence taxes, would be lower.

IT return only concerns itself with your holdings from which gains have realized. Same with your Capital Gains statement.

 

[jesuslovesme1973]

@crixus123 Found this at AMFI

https://www.amfiindia.com/Themes/Theme1/downloads/sai/sai44.pdf

De-duplication of Folios / Consolidation:In case an investor holds investments in multiple folios under the Fund, the AMC has the right to consolidate all the folios belonging to the same investor into one folio (target folio). All the information as available in the target folio including bank account details will be used for further processing. Accordingly, redemptions / switch-out requests made subsequent to the consolidation shall be processed based on the First-in-First-out (FIFO) methodology as if units were held in a single folio.

Which may essentially lay waste all the work done.

 

[cchc]

@jesuslovesme1973 That's the legal terms. But for all the funds I have invested so far, it was certainly possible to have distinct folios within the same house, and even the same fund.

I have never seen this being enforced, yet.

 

[wylted]

@cchc This might be a right that will only be exercised upon an explicit request by the investor

 

[resjudicata]

@jesuslovesme1973 AMFI only gives AMCs the right but not the obligation to consolidate multiple folios held by a single user. Since it adds unnecessary work, the AMCs only consolidate when the owner requests that specifically (and this does not attract tax).

The rest of the paragraph simply states that in case the folios are merged, then the the units will be queued according to the date of purchase, and FIFO will apply.

 

[reeseb]

@jesuslovesme1973

If the tax law is that it's FIFO within a folio or within a demat account, then your whole scheme is an

illegal

tax evasion strategy. All your scheme does is make it more difficult for the tax authorities to detect.

Others have mentioned opinions that it is within a folio.

I don't follow why this is tax evasion. I have an undertaking to not even go near such things. The tactic would mean that you actually list out all the transactions in ITR forms - you can carry forward losses only if you file ITR, and in time! Your comment on the previous point seems to suggest that this tactic is to avoid computation of taxes - it is not that at all. In fact, it would increase the amount of reporting and computation.

The tactic is definitely arranging one's affairs so as to lower or avoid taxes. This is definitely permissible by law and has been cited in many verdicts.

 

[jesuslovesme1973]

@reeseb

Others have mentioned opinions that it is within a folio.

In tax laws for equity, it's clearly mentioned that FIFO is within a depository account & not across depository. But it's not explicitly mentioned like that for MFs in the tax laws. But from the reasoning they gave for across the depository account in the laws, it seems that we can assume that it's per folio & not across folios for MFs. So your scheme would be fine. However, it seems that AMCs can consolidate Folios at their discretion.

I don't follow why this is tax evasion.

I didn't say it's tax evasion. I said depending on the law, it may be tax evasion. None of us seemed to be clear about the law when I wrote that.