Understanding capital gains on mutual funds

Investments in mutual funds can help investors grow wealth over time. This growth comes in the form of capital gains, among other avenues. Capital gain is the profit earned from the sale of mutual fund units or from the fund's internal trading of securities. When you sell mutual fund units at a value that is higher than the purchase price, the difference is considered a capital gain. The rise in the unit value happens if the value of the underlying securities – such as stocks or debt instruments – appreciates.
These profits are subject to a capital gains tax. This article tells you more about what capital gains are and why it is important for mutual fund investors to know about them.

• Table of contents

1. What are capital gains?
2. Types of capital gains on mutual funds
3. Capital gains tax on mutual funds
4. Impact of long-term capital gains tax on mutual fund returns
5. Impact of short-term capital gains tax on mutual fund returns

What are capital gains?

The term capital gain implies the rise in the value of a capital asset when it is sold. Simply put, a capital gain occurs when you sell an asset for a higher price than you paid for it. Residential plots, vehicles, artwork, bonds, stocks, and mutual funds fall under the capital asset category. Specifically, the profits earned from mutual funds are called capital gains on mutual funds.

Types of capital gains on mutual funds

There are two types of capital gains on mutual funds:

• Short-term capital gains: If capital assets (other than an equity-oriented fund) are held for a period of 36 months or less, then the gains obtained are known as short-term capital gains. Gains obtained from units of equity-oriented mutual fund held as capital asset for a period of 12 months or less are also considered as short-term capital gains. The tax levied on them is referred to as the short-term capital gains tax (STCG).
• Long-term capital gains: If the capital assets (other than an equity-oriented fund) are held for more than 36 months then the gains obtained are known as long-term capital gains. Also, units of an equity oriented mutual fund held as capital assets are treated as long-term capital assets if they are held for a period of more than 12 months. The tax levied on them is referred to as the Long-term Capital Gains Tax (LTCG).

Capital gains tax on mutual funds

All transactions involving capital assets are taxable under the Income Tax Act. The tax levied on short-term and long-term capital gains on mutual funds are known as STCG tax and LTCG tax respectively. Here’s how they are calculated:

• Short-term capital gains tax on mutual funds: You must pay a flat rate of 15% (Plus applicable surcharges and 4% cess) as STCG tax on equity and equity-oriented funds. In the case of debt and debt-oriented funds, STCG tax is calculated based on the individual’s income tax slab rate.
• Long-term capital gains tax on mutual funds: In the case of equity and equity-oriented funds, the tax rate on LTCG MF is 10% without indexation (Plus applicable surcharges and 4% cess) if the long-term capital gain is more than Rs.1 lakh in a financial year. Any long-term capital gains on mutual funds up to Rs.1 lakh in equity and equity-oriented funds are exempt from tax. In the case of debt and debt-oriented funds, LTCG tax is calculated based on the individual’s income tax slab rate.

Let’s understand this with a small example.

LTCG tax on equity and equity-oriented funds: If your long-term capital gains on mutual funds are Rs.90,000 in a financial year, you need not pay LTCG tax on it. However, if your LTCG MF is Rs.1.10 lakh in a financial year, then you will have to pay 10% of your long-term capital gains on mutual funds.

LTCG Tax on debt and debt-oriented funds: Irrespective of whether your capital gains on mutual funds Rs are.10,000 or Rs. 1 lakh in a financial year, you will have to pay tax based on your income tax slab rate.

Impact of long-term capital gains tax on mutual fund returns

If you compare LTCG with capital assets, here are the main points:

• The LTCG tax on debt and debt-oriented funds are calculated based on the individual’s tax slab rate.
• The tax on long-term capital gains on mutual funds in the equity and equity-oriented funds category is levied at 10% on capital gains exceeding Rs. 1 lakh. Capital gains of less than Rs. 1 lakh in a fiscal year are exempt from LTCG tax.
• The long-term capital gains tax on all other capital assets is 20%.

This clearly shows that the tax levied on LTCG on mutual funds is lowest for equity and equity-oriented funds. If you want to invest in capital assets, you can consider investing in equity and equity-oriented hybrid funds in the long term to save on capital gains tax. Also, long-term investment in equity-based mutual funds can help absorb the side effects of market volatility.
Different factors affect the returns from your mutual fund investments including the capital gains tax, expense ratio of the mutual fund, applicable cess and surcharge, and so on. While you cannot control or avoid paying most of them, you can save on the capital gains tax by holding on to your mutual funds, especially equity-based funds, for a long time. Remember the LTCG mantra: “The longer you hold on to your mutual fund units, the more tax-efficient they become.

Conclusion

To conclude, it is important to make yourself well-versed with the long-term capital gain tax on mutual funds. This will help you identify the duration for which you should hold your investments to minimise your tax liabilities, thereby allowing you to make an informed decision. You can also seek the help of a tax consultant for better understanding.

FAQs:

Are there any tax benefits of investing in Equity Linked Saving Schemes (ELSS) mutual funds?

For equity-oriented mutual funds, capital gains are taxable. The tax rate depends on the holding period. Units held for less than a year are subject to a short-term capital gains tax of 15% (plus applicable surcharges and 4% cess). Units held for more than a year are subject to a long-term capital gains tax of 10% (plus applicable surcharges and 4% cess).
For debt mutual funds, the capital gains are added to the investor’s annual income and taxed as per their income tax slab, irrespective of the holding period.

Is LTCG on mutual funds exempt under any section?

Capital gains of less than one year are exempt from long-term capital gains tax.

How to reduce tax on mutual fund gains?

For equity-oriented funds, the tax burden can be reduced by holding the investment for a year or more. This way, investors pay a long-term capital gains tax of 10% (plus applicable surcharges and 4% cess). In comparison, the short-term capital gains tax, levied on units redeemed in less than a year, is 15% (plus applicable surcharges and 4% cess). Additionally, capital gains of up to Rs 1 lakh are exempt from LTCG. So, investors can avoid being taxed if they plan their redemption amount such that their capital gains are less than Rs 1 lakh. However, this may not be feasible if a large amount is required.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.