All of us have jumped the equity stock market bandwagon since the lockdown happened. Increased liquidity led to a record breaking bull run in the past year and every seasoned investor stands to make better than average gains on their investments. Even you tried your hands in the stock market and are fetching decent returns on some blue chip stocks that you purchased. You are happy that you began your investment journey in stocks on a high. However, very little of us know that government wants a piece of pie of everything that you earn. The way you are bound to pay taxes on your salary, rental income or business income, you ought to share some part of the profits for your gains through shares as well. So, what is your tax liability in these cases? In today’s post, we try to explore the same.
Why Should I Learn About It?
Before we start, a small anecdote to signify the importance of taxation in our lives. I started investing due to parental pressure a few years ago. Little did I care about investing at that time and of course taxation wasn’t even considered remotely. My father invested my money in a mutual fund at that time and I was getting some good returns on it. Six months down the line, I wanted to take a vacation so I took out all the money. Learnings?
A. It is just not smart to withdraw money prematurely like that without any plans whatsoever. Instrument was meant to be held for a longer duration (>5 years)
B. I was charged an exit load, the amount that you are charged if you withdraw money before a stipulated time.
C. At the end of the year, our family CA told me that I had an ‘X’ amount of tax liability because some unprecedented gains hit my account.
All of this could’ve been avoided with some basic research. All the gains that I had made and was so excited about, went down the drain. As soon as I withdrew money, I exhibited my sheer naivety and ruined the compounding magic. Therefore, even if you can’t control your emotions, taxation is something that you should consider accounting anyway. I would rather go to an extent of saying that it’s better NOT to invest if you don’t want to get into taxation aspect of it.
What is Capital Gains from Share Market?
The concept is rather simple. In case your selling price of the stock is greater than the buying price, you have made a profit a.k.a capital gains on the transaction. Similarly, in case you have made a loss, it is called capital loss.
These capital gains tax (or capital loss) is divided into two sub-categories. Short Term Capital Gains (STCG) or Long Term Capital Gains (LTCG). Of course, this short term and long term is not a subjective term. The tax policy clearly defines the time period which will make a particular instrument as short or long term. Let’s explore both of them along with other nitty gritty in detail:
A. Short Term Capital Gains and Losses:
If the stocks held by you are sold within 12 month period of the purchase, you will either make a short term capital gain or incur a short term capital loss on it. Calculation of short term capital gains is as follows:
Calculation of STCG = Sales Price (-) Expenses on the Sale (-) Buying Price
Expenses on the sale include charges like brokerage or commission levied by the broker.
B. Long Term Capital Gains and Losses:
Prior to Financial Budget of year 2018, all long term capital gains made on selling equity or equity counterparts of mutual funds, were exempt from taxes under section 10(38). Post 2018, as per the provisions of the new budget, seller is liable to pay taxes on the capital gains from these instruments if the gain is exceeding Rs. 1 lakh. The gain made will not have any indexation benefit either. The period for which you need to hold a stock to qualify for long term is 1 year (erstwhile 3 years).
Say, you purchase a house for Rs. 50L in 1975. The value of house reaches to 1.5 Crores in the year 2020. The government gives you an option to account for inflation while calculating your gains. So, instead of paying taxes on Rs. 1 crore (1.5cr- 50L), you will pay taxes on 1 Crore(-) ‘X’ amount of indexation. This ability to incorporate ‘X’ amount in an instrument is called indexation benefit. Please note that this is a highly simplified version of indexation. In case you want to dig in deeper, please refer to this article from ET. I would not go into the details of how ‘X’ is calculated as LTCG anyway doesn’t have that benefit.
Coming back to the hero of the night, taxation. Now that we know there are two types of taxes STCG and LTCG, let’s find how is the tax calculated.
Short Term Capital Gain Tax:
STCG or Short Term Capital Gain Tax is fixed at 15% flat rate. You need not get into the details of your individual income tax slabs of 10%, 20%, 30% etc. Irrespective of your Tax Slabs, this rate is fixed. Also, if your annual taxable income is less than 2.5L, you can cover the shortfall using these gains and the pending amount will taxed at 15% + 4% cess on it.
→ If you are in the 30% tax bracket and make a short term capital gain of Rs. 75,000. Your tax will be
75000*15% = 11,250
*Please note that being in ANY OTHER tax bracket won’t change the tax liability at all.
→ If your annual taxable income is say 2L and you make a STCG of 75,000. In this case, you can adjust Rs. 50,000 against the income. So, your liability becomes:
Adjusting: 75,000 (-) 50,000 = 25,000
Tax: 15% of 25,000 = 3,750
Long Term Capital Gain Tax:
As mentioned earlier as well LTCG tax is at a flat rate of 10% (if gains > 1 lac). Basically, government wants to incentivize the behavior of long term investing to bring about a financial discipline in the investors.
→ If you are in 20% tax bracket and make a long term capital gain of Rs. 20,000. It is essentially tax free as the gains have not exceeded Rs. 1L
→ If you are in 20% tax bracket and make a long term capital gain of Rs.1,50,000. Your tax liability is:
= 1,50,000- 1,00,000
= 50,000 * 10% = 5,000
With the new rule coming up in 2018, people who were most affected were the ones who had held some stocks for generations. Imagine buying IPO of MRF in the year 1993 for Rs. 11. As I write this blogpost, the price of the MRF share is approximately Rs. 84,000. Now imagine someone had to pay 10% on such gargantuan gains.
Therefore, government came up with a concept where they would consider the price of the stock on 31st January 2018 as the deemed purchase cost and would tax the individuals basis the gains between 31st January, 2018 and the selling date.
Loss From Equity Shares:
As hard it might be for Robinhood Investors, but we have to remove our rose tinted glasses and realize that we can also make losses in the stock market. So how are these losses treated when it comes to income tax? Let’s explore in detail:
Short Term Capital Loss:
Any short term capital loss can be used to set off against any short term or long term capital gains. If the losses are not set off entirely, there is a provision to carry them forward for next 8 years. However, this is possible only for the cases where ITR was filed within the given timelines and the losses were clearly stated in the return.
So incase you have make Rs. 50,000 profits from 8 stocks and Rs. 4,000 loss from 4 stocks. If you decide to sell all 12 stocks in an year, you would only have to pay taxes on Rs. 50,000 (-) 40,000 = 10,000.
In another example, if you carry forward your loss of Rs. 50,000 and make LTCG of Rs. 1,50,000. You can set off your gains against the loss and hence make your gains for the year, tax free.
Long Term Capital Loss:
Back in the day, these were considered to be dead losses as you were not allowed to carry forward these losses or set it off against any gains. But, after the government changed the rules and put an LTCG, these losses are treated like any other short term capital losses. However, in this case, you can set off long term capital loss only against LTCG and NOT STCG. The carry forward period also remains the same at 8 years.
Often overlooked, taxes are one of the most important aspect of investing. If you don’t account for them carefully, you may end up in a big soup. I learnt it the hard way. So now, taxation has become an integral aspect while I try to know about any investment tool.
Do you consider taxation before investing?
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Until next time..