9.5 Setting Off Capital Gains and Losses under the Income Tax Act

The Asymmetry That Drives Every Question

The set-off rules are not symmetrical, and the asymmetry is the whole content of the sub-topic.

A short-term loss is the more flexible instrument. A long-term loss is confined.

The policy logic is that long-term gains are taxed at concessional rates, so allowing a long-term loss to shelter short-term gains taxed at higher rates would give the loss more value than the corresponding gain ever carried.

Capital Losses Stay Within the Capital Gains Head

A capital loss can be set off only against capital gains. It cannot be set off against:

• Salary income
• Income from house property
• Business or professional income
• Income from other sources, including interest and IDCW

An investor with a INR 5 lakh capital loss and INR 30 lakh of salary income cannot reduce the salary tax by a rupee. This is the most common misconception a distributor encounters.

Carry Forward

Where a loss cannot be absorbed in the year it arises:

• It may be carried forward for eight assessment years immediately following the year of loss
• It retains its character: a carried-forward long-term loss can still be set off only against long-term gains
• The income tax return must be filed within the due date for the loss to be carried forward at all

That last condition is absolute and is a favourite examination point. An investor who realised a substantial loss but filed a belated return forfeits the carry-forward entirely. There is no relief for the omission.

Worked Examples

Example 1 — short-term loss against long-term gain. In one financial year an investor has:

Short-term capital loss on an equity fund   = INR 1,80,000
Long-term capital gain on an equity fund    = INR 4,00,000

The short-term loss may be set off against the long-term gain:

Net long-term gain = 4,00,000 - 1,80,000 = INR 2,20,000
Less annual exemption                     = INR 1,25,000
Taxable                                   = INR   95,000
Tax at 12.5%                              = INR   11,875  (plus cess)

Example 2 — long-term loss cannot reach a short-term gain.

Long-term capital loss  = INR 2,50,000
Short-term capital gain = INR 3,00,000

The long-term loss cannot be set off against the short-term gain. The short-term gain of INR 3,00,000 is taxed in full at 20% for equity-oriented units, and the long-term loss of INR 2,50,000 is carried forward for up to eight assessment years to be set against future long-term gains.

Example 3 — order and carry forward.

STCL                        = INR 6,00,000
STCG                        = INR 2,00,000
LTCG                        = INR 1,50,000

Set off STCL against STCG   = 2,00,000 absorbed
Set off STCL against LTCG   = 1,50,000 absorbed
Absorbed in total           = INR 3,50,000
Carried forward             = INR 2,50,000 as short-term loss

The carried-forward amount retains its short-term character, so in future years it remains available against both types of gain — which is why realising short-term losses is more useful than realising long-term ones.

Tax-Loss Harvesting

The rules give rise to a legitimate planning technique. An investor holding a scheme at a loss may redeem to realise it, set the loss against gains realised elsewhere in the same year, and reinvest.

Points a distributor should raise before recommending it:

• The exit load may apply, which can exceed the tax saved on a small position
• The reinvestment starts a fresh holding period, which matters for future long-term treatment
• The investor is out of the market briefly between redemption and reallotment
• It is only worthwhile where there are gains to set off in the same year or a realistic expectation of them within the carry-forward window
• The investor should confirm the position with their tax adviser; a distributor should not compute the liability

Harvesting is a genuine technique, not a trick, but it is frequently recommended where the arithmetic does not support it.

Summary