Volatile markets? Here's how to make your losses work and save taxes for you

In December 2024, the Income Tax Appellate Tribunal (ITAT) in Mumbai ruled that taxpayers can set off short-term capital losses against long-term capital gains (LTCGs). The decision underscored the right to legitimate tax planning and marks a significant relief for investors frequently scrutinised during tax assessments. The ruling is particularly pertinent for stock market participants who face challenges in optimising their tax liabilities amidst stringent regulations. 

Capital gains and losses arise from the sale of capital assets, which are typically held for appreciation over time. These assets include equity shares, mutual funds, real estate, and bonds. Tax laws categorise these gains as either short-term or long-term, based on the holding period. Typically, short-term gains arise from assets held for less than 12 months, while long-term gains come from assets held beyond this period. 

The ITAT's decision allowed short-term capital losses from shares held for less than a year to be offset against any capital gain, whether short-term or long-term. However, long-term capital losses remain offsettable only against long-term gains. 

"With capital markets witnessing increased volatility in recent times, many taxpayers find themselves juggling both gains and losses in their investment portfolios. The Income Tax Act, 1961, offers a structured yet nuanced mechanism for setting off capital losses, which, when strategically applied, can significantly reduce one's tax outgo. Taxpayers with both short-term and long-term capital losses in FY 2025–26 can optimise their capital gains tax liability by following certain rules," said CA Niyati Shah, Vertical Head – Personal Tax at 1 Finance.

Capital assets and taxes

The classification of capital assets into short-term or long-term varies with the asset type. For instance, equity shares listed on stock exchanges and equity-oriented mutual funds are considered long-term if held for more than 12 months. Conversely, unlisted shares and immovable properties such as real estate are deemed long-term if held for over 24 months. Debt-oriented mutual funds acquired before April 1, 2023, required a holding period of more than 36 months to qualify as long-term. However, specified mutual funds acquired after this date are always considered short-term under Section 50AA, irrespective of their holding period. 

Nature of Capital Gains and Losses

Capital gains are classified under:

Type Holding Period Example Assets Tax Rate (FY 2025–26)

Short-Term Capital

Gain (STCG) ≤ 12 months Listed shares, equity- oriented Mutual Funds 20%

Long-Term Capital

Gain (LTCG) > 12 months Listed shares, non-equity assets 12.5% (post-indexation, where applicable)

Accordingly, losses from such transfers are termed short-term or long-term capital losses.

Rules of Set-Off: As per the Income Tax Act, there are specific rules governing the set-off of these losses:

1. Intra-head Adjustment First: Set-off is first made within the same head of income (i.e., Capital Gains)

2. Short-Term Capital Loss (STCL): Can be set off against both STCG and LTCG (This flexibility makes STCL a valuable tool in tax optimisation)

3. Long-Term Capital Loss (LTCL): Can be set off only against LTCG

4. Only if there is an unutilised loss, it can be carried forward up to 8 assessment years

Strategic Order of Set-Off for Optimal Tax Benefit

To ensure minimal tax liability, the following order is recommended:

1. Utilise STCL First: Set off short-term capital losses against short-term gains (taxed at 20%) and long-term gains (taxed at 12.5%) in order of a higher tax rate impact.

2. Apply LTCL Next: Since LTCL can only be set off against LTCG, apply this next. Important: Ensure no STCL is wasted on LTCG that could have been neutralised by LTCL.

3. Segregate Asset Types if Required: While capital gains are bucketed into ST or LT, the type of asset - equity vs. non-equity - also affects tax rate and exemption thresholds (e.g., ₹1.25 lakh exemption on LTCG from listed equity under Section 112A). Set off must be planned, keeping these in view.

Carry Forward Rules

● Filing Deadline Compliance: Losses must be reported in the income tax return (ITR) filed within the due date (July 31, unless extended)

● Loss Carry Forward Period: Both STCL and LTCL can be carried forward for up to 8 assessment years and used only against capital gains in subsequent years

Illustration: Mr. Fenil’s portfolio in FY 2025–26:

Type Amount (₹)

Short-Term Capital Loss ₹3,00,000

Long-Term Capital Loss ₹2,00,000

Short-Term Capital Gain ₹2,50,000

Long-Term Capital Gain (listed equity) ₹3,50,000

Tax Optimisation Plan

● Apply Section 112A exemption: From LTCG of ₹3.5 lakh (listed equity), apply Section 112A exemption of ₹1.25 lakh, taxable LTCG = ₹2.25 lakh

● Offset STCL: Use ₹2.5 lakh STCL to fully offset STCG, then STCG becomes Nil. The remaining ₹50,000 STCL set off against LTCG, Balance LTCG = ₹1.75 lakh

● Offset LTCL: Use ₹1.75 lakh LTCL to fully offset balance LTCG, then LTCG becomes Nil

● Carry Forward: ₹25,000 LTCL remains unabsorbed and can be carried forward for 8 Assessment years if Income Tax Return is filed within the due-date

Outcome:

Component Before Set-Off After Set-Off

Taxable STCG ₹2,50,000 ₹0

Taxable LTCG (post-

112A) ₹2,25,000 ₹0

Tax Payable on Gains ₹0 Nil

Carried Forward Loss – LTCL ₹25,000

Plan proactively, file on time

Understanding the Income Tax Act's provisions on capital loss set-off is fundamental for investors aiming to optimise their tax responsibilities. Whether dealing with losses from equity shares, mutual funds, real estate, or gold, taxpayers can strategically offset short-term capital losses against both short-term and long-term gains. 

"The key to capital loss optimisation lies not only in understanding the set-off rules but also in their judicious application based on tax rates, asset types, and filing discipline. Investors should ideally consult their tax advisors at the end of the financial year to assess portfolio performance and chart out a loss-harvesting strategy if needed," Shah noted.