How to Avoid LTCG Tax on Mutual Funds

In the 2024 Union Budget, Finance Minister Nirmala Sitharaman reintroduced long-term capital gains (LTCG) tax on equity investments, bringing an important change to the taxation of investment gains. Earlier, profits from equity investments held for more than one year were fully exempt from tax, making them a popular choice for long-term investors. Under the revised rules, investors must pay tax on eligible gains earned from such investments upon redemption. While mutual fund gains are taxable, tax harvesting can help reduce the LTCG tax burden legally. For equity funds, LTCG tax applies only when annual gains exceed Rs. 1.25 lakh. Careful investment planning and timely redemptions can help minimise tax liability. Read the full blog to learn more.

What is Capital Gains Tax?

Capital gains refer to the profit earned by an investor when they sell an asset for a price higher than its purchase cost. These assets can include real estate, vehicles, jewellery, stocks, and other securities.

Capital gains are subject to taxation in India and are classified into two types: short-term and long-term. Short-term capital gains (STCG) apply when assets like property are sold within 36 months of purchase, or when equity shares and listed securities are sold within 12 months. On the other hand, long-term capital gains (LTCG) apply if these assets are held for more than 36 months and 12 months respectively.

The tax treatment for STCG and LTCG varies. If STCG is not covered under securities transaction tax (STT), it is added to the investor’s total income and taxed as per the applicable income tax slab. However, if STCG falls under STT, it is taxed at a flat rate of 15% along with surcharge and cess. For LTCG, a 20% tax rate is applied, also with surcharge and education cess.

What is Long-Term Capital Gain (LTCG)?

Long-Term Capital Gains refer to profits made from selling an asset held for a specified period, usually over a year, though this timeframe varies by asset type. For example, listed equity shares and equity-oriented mutual funds are considered long-term assets if held for over 12 months. In contrast, unlisted equity shares and immovable property like land, buildings, or houses must be held for over 24 months to qualify. Debt-oriented mutual funds and other assets are categorized as long-term if held for more than 36 months.

The tax rates for LTCG differ based on the asset class. Gains from listed equity shares and equity-oriented mutual funds exceeding ₹1 lakh in a financial year are taxed at 10%. LTCG from other assets is typically taxed according to individual income tax slab rates. This classification and varied tax structure aim to balance the tax treatment of long-term gains across various assets.

Key changes introduced in ITR forms for Assessment Year (AY) 2025–26

• Inclusion of Long-Term Capital Gains (LTCG) in ITR-1 and ITR-4

  
  

  Earlier, taxpayers earning long-term capital gains had to use detailed forms like ITR-2 or ITR-3. Now, individuals with LTCG up to Rs. 1.25 lakh from listed equity shares or equity-oriented mutual funds (under Section 112A) can file using simpler forms — ITR-1 (Sahaj) or ITR-4 (Sugam) — provided they have no carried forward losses.

• Separate Reporting of Capital Gains Based on Transaction Dates

  
  

  The revised ITR forms now mandate separate disclosure of capital gains for transactions made before and after July 23, 2024. This change reflects the updated tax rules introduced in Budget 2024, which reduced the LTCG tax on real estate from 20% with indexation to 12.5% without indexation.

• Reporting Buyback Proceeds as Deemed Dividends

  
  

  Effective October 1, 2024, proceeds from share buybacks by domestic listed companies are to be treated as deemed dividends. These must now be reported under ‘Income from Other Sources’. The corresponding capital gains schedule should show zero sale proceeds, and the cost of acquisition can be claimed as a capital loss, eligible for carry-forward for up to eight years.

• Enhanced Capital Gains Reporting for ITR-7 Filers

  
  

  Trusts, NGOs, and similar entities filing ITR-7 must now report capital gains separately for transactions occurring before and after July 23, 2024, ensuring accurate tax computation under the new capital gains framework.

• Higher Threshold for Asset and Liability Disclosure

  
  

  In the ITR-2 form, the reporting threshold for assets and liabilities has been increased to Rs. 1 crore, reducing compliance requirements for taxpayers with lower-value holdings.

Taxation on mutual funds

Here are a few important points to help you understand taxation on mutual funds:

Also read: Long Term Capital Gain Tax on Property

Is there a way to reduce capital gains tax on short term gains?

Reducing capital gains tax on short-term gains can be challenging, but there are a few strategies to consider. Offset gains with capital losses by selling underperforming investments, a tactic known as tax-loss harvesting. Utilise tax-advantaged accounts such as ISAs, which shield gains from tax. Additionally, consider holding investments longer to benefit from lower long-term capital gains rates. Strategic gifting or charitable donations of appreciated assets can also provide tax relief. Consulting a financial advisor is advisable to ensure compliance with tax regulations while maximising potential savings.

How to avoid long term capital gain tax (LTCG) on mutual funds?

Below are some ways in which you can reduce LTCG tax on mutual funds.

1. Offset gains with losses

One of the easiest ways to lower LTCG tax on mutual funds is by offsetting capital gains with capital losses. If you hold mutual fund units or other investments that are performing poorly, selling them can help reduce your overall taxable gains.

For example, if you earn Rs. 10,000 in capital gains from one mutual fund and incur a loss of Rs. 4,000 from another investment, you can use the loss to offset the gain. This reduces your taxable gain to Rs. 6,000. By using this approach, you can lower your tax liability while improving the overall efficiency of your investment portfolio.

2. Use a Systematic Withdrawal Plan (SWP)

A Systematic Withdrawal Plan (SWP) allows you to withdraw a fixed amount from your mutual fund investment at regular intervals. Spreading withdrawals over several years can help keep your gains within the annual LTCG exemption limit of Rs. 1.25 lakhs.

For instance, instead of withdrawing Rs. 5 lakhs at once and creating a larger taxable gain, you could withdraw Rs. 1 lakh each year over five years through an SWP. This approach can help you manage taxes more effectively while providing a steady income stream.

3. Leverage tax harvesting

Tax harvesting is a useful strategy for reducing long-term capital gains tax on mutual funds. It involves selling mutual fund units to realise gains up to the tax-free limit during a financial year. By carefully timing these transactions, you can utilise the annual exemption limit and minimise future tax liabilities.

How It Works:

• If your mutual fund portfolio has appreciated by Rs. 2 lakhs, you can sell enough units to realise gains of Rs. 1.25 lakhs.
• You may then reinvest the proceeds into the same or another mutual fund after a reasonable gap, helping avoid scrutiny under the GAAR (General Anti-Avoidance Rules) framework.
• This process can be repeated every year to make use of the available exemption.
• Regularly booking gains within the exempt limit helps prevent the build-up of large taxable gains over time.

4. Invest in tax-efficient mutual fund options

Different mutual funds offer different levels of tax efficiency. Selecting tax-efficient investment options can help reduce the impact of LTCG tax on mutual funds over the long term.

Some tax-efficient options include:

• Index Funds: These funds are passively managed and generally have lower portfolio turnover, which may result in lower taxable gains compared to actively managed funds.
• Exchange-Traded Funds (ETFs): ETFs are often structured in a way that reduces capital gains distributions, making them a tax-efficient investment choice.
• ELSS (Equity Linked Savings Schemes): Although LTCG tax may apply, ELSS funds provide tax deductions of up to Rs. 1.5 lakhs under Section 80C, helping reduce overall taxable income.

Choosing suitable tax-efficient funds can support long-term wealth creation while helping you manage taxes more effectively.

5. Hold investments for the long term

Frequent buying and selling of mutual fund units can create multiple taxable events. Holding investments for longer periods can help reduce tax outgo and allow you to benefit from the power of compounding.

• Short-Term Capital Gains (STCG) on equity funds are taxed at applicable rates if the units are held for a short period, as per prevailing tax rules.
• Long-Term Capital Gains (LTCG) tax applies only when gains exceed the applicable exemption limit.

Benefits of long-term holding:

• Potential for higher returns through compounding.
• Fewer transactions can result in lower tax implications.
• Better utilisation of available tax exemptions and investment benefits.
• Encourages a disciplined and goal-oriented investment approach.

6. Gift mutual fund units to family members

Another way to reduce the overall tax burden is by gifting mutual fund units to eligible family members who fall under lower tax brackets. Gifts to specified family members are generally not taxed in India, making this a useful strategy for tax planning.

How It Works:

• If you fall in a higher tax bracket and a family member, such as a retired parent or adult child, falls in a lower tax bracket, transferring mutual fund units to them may result in gains being taxed at their applicable rate.
• This can help optimise the overall tax liability of the family while supporting long-term financial planning.

Before using this strategy, it is advisable to understand the applicable tax rules and clubbing provisions to ensure compliance with current regulations.

How tax harvesting helps reduce capital gains tax?

Tax harvesting, or tax-loss harvesting, is a strategy employed by investors to reduce their capital gains tax liability. This involves selling investments that have decreased in value to offset the capital gains realised from the sale of profitable investments. By balancing the gains with losses, the overall taxable capital gains can be significantly reduced.

For instance, if an investor has realised a capital gain of Rs. 10,000 from the sale of a successful investment, but also has an investment that has lost Rs. 4,000, selling the underperforming asset can offset the gain. The net taxable gain would then be reduced to Rs. 6,000, thereby lowering the capital gains tax owed.

This strategy can be particularly beneficial towards the end of the financial year, allowing investors to make strategic decisions about their portfolios. Additionally, the losses can be carried forward to offset future gains if they exceed the current year's gains.

It’s essential, however, to adhere to the ‘bed and breakfast’ rule in the UK, which prevents repurchasing the same or a substantially similar investment within 30 days of the sale. This rule ensures that the sale is not merely a superficial transaction designed solely for tax benefits. Consulting with a financial advisor can help navigate these rules and optimise the tax benefits of harvesting losses.

Also read: How to Calculate Capital Gains Tax on Mutual Funds

Why holding on to your investment is a better option?

Selling your mutual fund holdings can trigger capital gains tax, which depends on how long you have held the investment.

Here's a breakdown:

• Short-Term Capital Gains (STCG): Sold within 1 year - Taxed at 20% of your gains.
• Long-Term Capital Gains (LTCG): Sold after 1 year: 
  • Up to Rs. 1.25 lakh per year - Exempt from tax.
  • Exceeding Rs. 1.25 lakh - Taxed at 12.5% without indexation (adjustment for inflation).

Strategies to minimise LTCG Tax:

• Invest for the Long Term: Hold your investments for longer periods to benefit from the Rs. 1.25 lakh exemption and potentially avoid LTCG tax altogether.
• Tax-Efficient Investing: Consider consistent performers and avoid frequent portfolio churning (buying and selling) to minimise taxable gains.

Choosing the right mutual funds

Here are some fund categories that can help with long-term investing:

Important Note: Sector Funds are riskier due to their focus on a specific industry. Consider them only if you have strong knowledge of that sector.

How to calculate capital gains tax on mutual funds?

To understand how to minimise your capital gains tax, it is crucial to comprehend the taxation principles governing mutual funds. “Debt-oriented” and “Equity-oriented” mutual funds, are subject to distinct tax regimes, outlined as follows.

Gains from Debt Mutual Funds held for 3 years (36 months) or less before redemption are deemed Short Term Capital Gains (STCG) and taxed at your slab rate, potentially reaching up to 30%. Units held for over 3 years qualify for Long Term Capital Gains (LTCG) tax. Pre-Budget 2023, LTCG on debt funds attracted a 20% tax with indexation benefit. Post-Budget 2023, gains from debt funds made post April 1st 2023, will be taxed according to your income tax slab, without indexation benefit.

For Equity Funds, gains from units held up to 1 year (12 months) before redemption are considered Short Term Capital Gains (STCG) and taxed at a rate of 20%. If held for over 1 year, they attract Long Term Capital Gains (LTCG) tax. LTCG tax for Equity Mutual Funds is 12.5% on gains exceeding Rs. 1.25 lakh annually. Thus, if your total gains are Rs. 1.45 lakh, only Rs. 20,000 is taxable at 12.5%, while the remaining Rs. 1.25 lakh remains tax-free.

Hybrid mutual funds are subject to specific taxation rules based on their equity and debt components. For the equity component, similar to equity funds, long-term capital gains are taxed at 12.5% on profits exceeding Rs. 1.25 lakh annually, while short-term capital gains incur a 20% tax. On the other hand, the debt component follows the taxation structure of pure debt funds. Capital gains from the debt part are added to your income and taxed according to the applicable income tax slab. Long-term capital gains from the debt component attract a 20%.

How to minimise LTCG tax liability

Here is the rewritten version in approximately 100 words, keeping the same format and using simple, professional UK English:

Here are some strategies to reduce your LTCG tax liability:

Hold investments for more than one year: Keeping your investments for over one year allows you to qualify for long-term capital gains tax treatment, which is generally taxed at a lower rate of 10%.

Use the Rs. 1 lakh exemption: Plan your withdrawals carefully to keep your annual long-term capital gains within the Rs. 1 lakh exemption limit and avoid LTCG tax.

Consider tax-exempt investments: Certain investment options, such as tax-free bonds, may offer capital gains tax benefits.

Maximise tax-advantaged accounts: Investing through schemes such as NPS and EPF can help improve tax efficiency.

Offset gains with losses: Tax loss harvesting allows you to set off eligible capital losses against gains, reducing your overall taxable income.

Conclusion

In conclusion, mutual fund investments require a thorough understanding of taxation principles to optimise returns and minimise tax liabilities. The strategies discussed, such as tax harvesting and leveraging losses, offer valuable tools for you to mitigate capital gains tax burdens effectively.

By implementing tax harvesting, you can strategically manage your equity mutual fund holdings to keep long-term returns below the Rs. 1.25 lakh threshold, thus avoiding long-term capital gains tax upon redemption. Additionally, capitalising on losses enable you to offset long-term capital losses against gains, reducing your overall tax liabilities.

It is essential for you to evaluate your investment goals, risk tolerance, and tax implications carefully. Moreover, staying informed about regulatory changes and tax policies is crucial for making informed investment decisions.

In essence, by employing prudent tax planning strategies, you can enhance overall investment outcomes and build long-term wealth.

Essential tools for mutual fund investors