How are capital gains taxed on mutual funds? Capital gains, as the name suggests are profits generated by selling or redeeming mutual funds. If you buy a mutual fund unit at Rs.100 and sell at Rs.105, then the Rs.5 difference will be treated as capital gains. In the same way, if you buy a fund unit at Rs.100 and sell at Rs.96, then the difference of Rs.4 will be treated as a capital loss. Capital gains are income and are taxed under the Income Tax Act. Tax status of mutual fund holdings is based on 2 factors. Firstly, it is based on whether the fund is an equity fund or debt. The definition of equity fund is if at least 65% of the AUM is held in equities. Otherwise it is classified as a debt fund. The second consideration is whether the capital gains are long term or short term. Both equity and debt funds are taxed on capital gains at different rates. Let us look at income tax on mutual funds investment in India in general and tax on equity and debt mutual funds capital gains in particular.
Capital gains (LTCG and STCG) on equity funds
The first step to calculating capital gains tax is to classify the as short term capital gains (STCG) or long term capital gains (LTCG). That depends on the holding period. In case of equity funds, holdings above 1 year will be treated as LTCG. Any fund held for a period of less than 1 year will be STCG. This refers to the gap between the purchase and sale dates and has nothing to do with the financial year.
In case of equity funds, the STCG (less than 1 year) will be taxed at a flat rate of 17.472% (15% tax + 12% surcharge + 4% cess). LTCG on equity funds were tax free in the hands of the investor till the fiscal year 2017-18. Effective April 2018, there is a tax of 11.648% (10% tax + 12% surcharge + 4% cess) on LTCG on equity funds. However, there will be a basic exemption of Rs.1 lakh available in this case and only LTCG above that limit will be taxed. However, this tax on LTCG will be imposed flat without the benefit of indexation.
AMP Equity FundSTCGAMP Equity FundLTCG (pre-Apr18)LTCG (post-Apr18)Capital GainRs.50,000Capital GainRs.250,000Rs.250,000Basic ExemptionNilBasic ExemptionN.A.Rs.1,00,000Taxable GainRs.50,000Taxable GainRs.250,000Rs.150,000Tax Rate17.472%Tax Rate0%11.648%Tax on GainRs.8,736Tax on GainNilRs.17,472Net Capital GainRs.41,264Net Capital GainRs.2,50,000Rs.2,32,528
The above chart captures the calculation of short term capital gains (STCG) and LTCG on equity funds under the pre-Apr 2018 and the post-Apr 2018 scenarios.
Capital gains (LTCG and STCG) on debt funds
In case of debt funds (less than 65% in equities), the definition of long term is a holding period of more than 3 years. Any debt fund holding of less than 3 years will be classified as short term capital gains for the purpose of taxation. Being classified as STCG or LTCG can make a bid difference to the taxation of debt funds. That is because not only are LTCG taxed at a lower rate but LTCG on debt funds also getting the added benefit of indexation.
In case of debt funds, the STCG (less than 3 years) will be taxed at your peak income tax rate applicable (10% or 20% or 30%). Since it will be added to your regular income, your effective rate of tax at the highest bracket will be 30.9%. LTCG on debt funds will continue to attract a tax of 23.296% (20% tax + 12% surcharge + 4% cess). However, in this case there will be the benefit of indexation available. The purchase cost can be indexed to the sale date based on the IT Department’s Cost Inflation Index and tax needs to be paid only on the indexed gains. This indexation helps to substantially reduce the tax incidence in case of long term capital gains.
In fact, here you can go one step further and get the benefit of double indexation too. How does that work. Say, you purchased a debt fund on March 29th 2015 and sold it on April 03rd 2018. Actually, you have held it for a period of just 3 years and 5 days. However, since this trade straddles 4 financial years (2014-15 to 2018-19), you get the benefit of one more year of indexation thus reducing your tax liability even further.
Gains are fine; but what if you have losses?
Not to worry; losses can be adjusted against profits and they can also be carried forward. For example, short term losses can be set of against STCG and LTCG, but long term losses can only be set off against LTCG. You pay tax on the net capital gains after adjusting for these losses. But what happens if your losses are more than your gains? The answer is that you can not only write off the accumulated losses of last 8 years against current profits but you can also carry forward unadjusted losses for a period of 8 assessment years. This is an important aspect to understand to reduce your capital gains taxes substantially.