Mutual fund investments consist of both debt and equity investments. A redemption of mutual fund investments gives rise to capital gain or loss, which are taxed as capital gains. A loss, however, can be set-off against other taxable gains from other asset classes. We discuss the tax treatment of the gains and losses below.
Debt mutual funds typically invest in government securities, corporate bonds, treasury bills, commercial paper, among others, which are usually deemed risk-free. Such funds provide you with returns in the form of dividend and capital gains. Debt mutual funds also bear market risks which may emerge from a liquidity crisis, credit risks or other risks associated with corporates or interest rate risk.
Debt funds held for more than three years are a long-term capital asset and are eligible for indexation while computation of tax payable post redemption. Simply put, you can adjust your cost/investment for inflation as below:
Indexed cost of acquisition = Purchase price * CII of year of sale/CII of the year of purchase
The long-term capital gains = Sale price minus the indexed cost of acquisition. The long-term gains are taxable at 20% (plus education cess).
However, if you realise less on the redemption of your investments, you have a long-term capital loss. You can set-off or reduce the long-term loss against a taxable long-term capital gain from any other asset. For example, a loss from redemption in debt mutual fund can be set-off against a taxable equity fund gain in the same year.
In a case you are not able to set-off the loss in the same year, you can carry forward the long term loss for the next eight years and set off against future long term gains from any asset.
On the other hand, debt mutual funds held for less than three years are a short-term capital asset. The short-term gains are taxable as per the income slab rates of the investor (plus education cess). In case your income falls in the highest slab of 30%, your short-term gain will be taxable at that rate. In the case of a short-term capital loss, you can set-off the loss against any taxable short-term or long-term capital gain of the same year.
In a case where you are unable to set-off the short-term loss, you can carry forward the loss for the next eight years and set off against future short-term or long-term capital gains.
Most equity funds have exposure to equities, in part or whole. You can choose from a variety of equity funds offered by mutual fund houses ranging from ELSS, large-cap, sector-based funds, among others.
You can redeem your ELSS investments only after a three year mandatory lock-in period. The redemption of ELSS is taxed as a long-term capital investment. An equity-oriented fund held for more than one year becomes a long-term capital asset. The excess of your sale value over the cost of your investment will be your long term capital gain or loss. The long term capital gain you earn is tax-exempt up to Rs 1 lakh. The long-term gains above Rs 1 lakh are taxable at 10% (plus education cess).
However, if you realise less than your investment, the excess of the cost over the sale becomes your long-term capital loss. You can set-off or reduce your long-term capital loss with taxable long-term capital gains from the sale of any other asset. In a case you are not able to set-off, you can carry forward the long-term loss for the next eight years and set off against future long-term gains.
Tax treatment of dividends
Apart from capital gains or loss, ELSS investments provide you with regular dividends if you choose a dividend option. Investors have to pay tax on dividends from FY 2020-21 onwards. An investment in ELSS qualifies for a tax deduction up to Rs 1.5 lakh.
Archit Gupta is CEO of ClearTax. Views are his own