Setting Off Capital Gains & Losses — Practical Examples
Definition
The Income Tax Act allows taxpayers to set off capital losses against capital gains to reduce their tax liability. Short-Term Capital Loss (STCL) can be set off against both Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG). However, Long-Term Capital Loss (LTCL) can ONLY be set off against Long-Term Capital Gains (LTCG) and NOT against STCG. If losses remain unabsorbed after set-off in the current year, they can be carried forward for up to 8 subsequent assessment years — but only if the Income Tax Return is filed on or before the due date. Tax-loss harvesting is a strategy where investors deliberately book losses by redeeming losing investments and then reinvesting, to reduce current-year capital gains tax.
In Simple Words
This is one of the most practical and underused areas of tax planning, and it is where a knowledgeable distributor adds enormous value. Most clients see their portfolio as green (profit) and red (loss) funds and feel bad about the losses. But a seasoned advisor sees losses as a tax asset. The rules can be understood through a simple 2x2 grid — short-term and long-term on one axis, gains and losses on the other. STCL is the most flexible — it can be used to reduce both STCG and LTCG. But LTCL is restricted — it can only reduce LTCG. It cannot touch STCG. This asymmetry is crucial for tax planning. The order of set-off matters: first, set off losses against same-type gains (STCL against STCG, LTCL against LTCG). Then, use any remaining STCL against LTCG. If losses still remain, carry them forward. The carry-forward is valid for 8 years, but — and this is critical — the ITR must be filed before the due date of that year. Filing a belated return forfeits the right to carry forward the loss. Tax-loss harvesting is a strategy where investors strategically redeem investments that are in loss near the end of the financial year, book the loss for tax purposes, and immediately reinvest in the same or a similar fund. The key is that an unrealized loss is converted into a realized loss that can offset realized gains. For SIP investors, this is particularly powerful because different SIP installments may have different profit/loss levels.
Real-Life Scenario
Consider the case of Ramesh, who has the following capital gains and losses in FY 2024-25: • Equity Fund A: STCG of Rs 2,50,000 (redeemed within 12 months) • Equity Fund B: STCL of Rs 1,80,000 (redeemed within 12 months) • Equity Fund C: LTCG of Rs 4,00,000 (redeemed after 12 months) • Debt Fund D: LTCL of Rs 60,000 (redeemed after 24 months) Step 1 — Set off STCL against STCG: STCG from Fund A = Rs 2,50,000 STCL from Fund B = Rs 1,80,000 Net STCG = Rs 2,50,000 - Rs 1,80,000 = Rs 70,000 Step 2 — Set off LTCL against LTCG: LTCG from Fund C = Rs 4,00,000 LTCL from Fund D = Rs 60,000 Net LTCG = Rs 4,00,000 - Rs 60,000 = Rs 3,40,000 Step 3 — Apply equity LTCG exemption: Taxable LTCG = Rs 3,40,000 - Rs 1,25,000 = Rs 2,15,000 Step 4 — Calculate tax: STCG tax = Rs 70,000 x 20% = Rs 14,000 LTCG tax = Rs 2,15,000 x 12.5% = Rs 26,875 Total tax = Rs 40,875 + 4% cess = Rs 42,510 Without any set-off, Ramesh would have paid tax on Rs 2,50,000 STCG + Rs 4,00,000 LTCG = Rs 50,000 + Rs 34,375 = Rs 84,375 + cess. The set-off saved him approximately Rs 41,000.
Key Points to Remember
Formula
Set-Off Rules: 1. STCL set-off: Against STCG first, then remaining STCL against LTCG 2. LTCL set-off: Against LTCG ONLY (never against STCG) 3. Carry forward: Unabsorbed losses for 8 assessment years Tax-Loss Harvesting Formula: Tax Saved = Loss Booked x Applicable Tax Rate For equity STCL used against STCG: Tax saved = STCL x 20% For equity STCL used against LTCG: Tax saved = STCL x 12.5% For LTCL used against LTCG: Tax saved = LTCL x 12.5%
Numerical Example
Tax-Loss Harvesting Example with SIP: Preeti runs a Rs 20,000/month SIP in a mid-cap fund from Jan to Dec 2024. In March 2025, the market has corrected. Her 12 SIP installments: • Jan-Mar 2024 (3 installments, Rs 60,000): Current value Rs 52,000 — Loss Rs 8,000 (units held < 12 months = STCL) • Apr-Jun 2024 (3 installments, Rs 60,000): Current value Rs 55,000 — Loss Rs 5,000 (STCL) • Jul-Sep 2024 (3 installments, Rs 60,000): Current value Rs 63,000 — Gain Rs 3,000 (STCG) • Oct-Dec 2024 (3 installments, Rs 60,000): Current value Rs 64,000 — Gain Rs 4,000 (STCG) Total investment: Rs 2,40,000. Current value: Rs 2,34,000. Unrealized loss: Rs 6,000. But Preeti also has equity LTCG of Rs 3,00,000 from another fund she redeemed. Tax-loss harvesting strategy: Redeem only the loss-making Jan-Jun installments. Realized STCL = Rs 8,000 + Rs 5,000 = Rs 13,000 Set off Rs 13,000 STCL against Rs 3,00,000 LTCG: New taxable LTCG = Rs 3,00,000 - Rs 13,000 - Rs 1,25,000 (exemption) = Rs 1,62,000 Tax = Rs 1,62,000 x 12.5% = Rs 20,250 Without harvesting: Tax on Rs 3,00,000 LTCG = (Rs 3,00,000 - Rs 1,25,000) x 12.5% = Rs 21,875 Tax saved = Rs 21,875 - Rs 20,250 = Rs 1,625 Preeti immediately reinvests the redeemed Rs 1,07,000 back into the same mid-cap fund (or a similar one). Her market exposure is maintained, but she has Rs 1,625 extra in her pocket. Over many years with larger amounts, this adds up significantly.
Frequently Asked Questions
Test Your Knowledge
4 questions to check your understanding
Long-Term Capital Loss from mutual funds can be set off against:
Summary Notes
STCL can offset both STCG and LTCG; LTCL can only offset LTCG — never STCG
Carry forward of unabsorbed losses for 8 assessment years — ITR must be filed before due date
Tax-loss harvesting: book losses by redeeming losing investments, then reinvest to maintain exposure
India has no wash sale rule (unlike the US) — investors can redeem and reinvest on the same day
Capital losses cannot be set off against salary, business, rental, or any non-capital income
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What you’ll learn in Taxation of Mutual Funds
Understand the complete tax treatment of mutual fund investments — STCG, LTCG, dividend taxation, stamp duty, TDS rules, and Section 80C benefits. Practical tax knowledge every distributor must have.
Frequently asked questions
How does the tax department determine if a fund is equity-oriented?
SEBI requires AMCs to maintain monthly portfolio disclosures. The Income Tax Act considers a fund equity-oriented if it invests a minimum of 65% of total proceeds in equity shares of domestic companies. This is computed as an average of monthly allocations. If the average dips below 65%, the fund loses equity tax status for that period.
Why do Fund of Funds get debt tax treatment even when they invest in equity funds?
Because a Fund of Fund holds units of another mutual fund scheme, not direct equity shares. The Income Tax Act specifically requires 65% investment in equity shares of domestic companies. MF units are not equity shares, so FoFs are classified as non-equity for tax purposes regardless of the underlying fund type.
Are arbitrage funds really better than liquid funds for tax purposes?
Yes, for investors in the 30% tax bracket, arbitrage funds are significantly more tax-efficient. Returns are similar (6-7%), but liquid fund gains held under 24 months are taxed at slab rate (up to 30%), while arbitrage fund gains held over 12 months qualify for equity LTCG at 12.5% with a Rs 1.25 lakh exemption. This can save over 17% in tax.
What changed for debt fund taxation after April 2023?
From April 1, 2023, "specified mutual funds" — those with less than 35% equity allocation — lost the benefit of indexation and LTCG treatment entirely under Section 50AA. Regardless of holding period, gains are taxed at the investor's income tax slab rate. This affected most pure debt funds, liquid funds, and money market funds. Note: Gold ETFs and international funds were subsequently given a 24-month LTCG holding period at 12.5% under Budget 2024 provisions.
How are gold funds and silver funds classified for tax?
Gold ETFs, gold fund of funds, and silver ETFs are classified as non-equity. Post Budget 2024, Gold ETFs and similar funds have a 24-month holding period for LTCG, taxed at 12.5% without indexation. STCG (within 24 months) is taxed at the investor's slab rate. The earlier benefit of LTCG with indexation after 3 years has been removed.
Is equity STCG always 20% irrespective of the investor's income level?
Yes, post July 2024 Budget, equity STCG is a flat 20% regardless of the investor's income tax slab. However, surcharge may apply based on total income levels, and 4% Health & Education Cess is always applicable on top. So the effective rate could be slightly higher than 20% for high-income individuals.
What happens when an investor switches from one equity fund to another within 12 months?
A switch is treated as a redemption from the first fund and a fresh purchase in the second fund. If the switch happens before 12 months, the gain from the first fund is STCG taxed at 20%. The holding period of the second fund starts fresh from the switch date.
Is there any exemption on equity STCG similar to the LTCG exemption?
No. The Rs 1.25 lakh exemption applies only to equity LTCG (long-term capital gains). There is no exemption limit for STCG. Even a gain of Rs 100 on equity funds held for less than 12 months is taxable at 20%.
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