Capital Gains on Mutual Funds Explained

What are Capital Assets? Anything you own, whether for personal or for investment purposes, is referred to as a capital …

What are Capital Assets?

Anything you own, whether for personal or for investment purposes, is referred to as a capital asset. It includes all kinds of property, movable or immovable, tangible or intangible, fixed or circulating. Capital assets can be classified as financial assets (bonds, stocks, etc.) and non-financial assets (real estate, machinery, etc.).

What are Capital Gains?

When you sell your capital assets for a higher price than you bought them at, the difference is a capital gain. Any income from the sale of a capital asset made in the previous year is taxable under the head ‘Capital Gains’.

Mutual Funds are capital assets, so any income from the sale of Mutual Funds is classified as a capital gain and is taxable.

What is Capital Gain on Mutual Funds?

The profit you generate when you sell or redeem your mutual fund units are referred to as capital gains on Mutual Funds. There are generally two types of capital gains decided by the period of holding: Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG). The tax applicable on these capital gains is referred to as ‘Capital Gains Tax’.

What are Short and Long Term Capital Gains

1. Short Term Capital Gains (STCG)

If you sell any units in an Equity Mutual Fund scheme within a year of purchase, your gain will be considered as a short-term capital gain. For anything other than Equity funds (eg Debt, Liquid, etc), this is slightly different. The holding period needs to be less than 3 years for the gains to be considered as short term capital gains.

2. Long Term Capital Gains (LTCG)

If you decide to wait it out for more than a year on any investments in an equity mutual fund scheme, the profits on your investment will be considered as long term capital gains. Again, with debt funds, you’ll need to hold on to them for more than 3 years for the gains to be considered as long term capital gains.

In summary:

Funds Short-term Long-term
Equity funds Less than 12 months
12 months and more
Balanced funds (equity-oriented) Less than 12 months
12 months and more
Balanced funds (debt-oriented) Less than 36 months
36 months and more
Debt funds Less than 36 months
36 months and more

Capital Gains Tax Rates on Mutual Funds

  1. Equity funds: On equity funds, your short term capital gains will attract a 15% capital gains tax. No tax was charged on long term capital gains until January 31, 2018, but currently, long term capital gains are taxed at 10%.
  2. Debt fund: You pay short term capital gains tax on debt funds as per your current income tax rates (10, 20 or 30%). Long term capital gains however are taxed at 20% (with indexation benefits). Indexation is a process used to adjust your original cost upwards by means of a government-issued index. This helps you adjust for inflation over the period you’ve held your capital assets – reducing your tax liability.

In summary:

Type of Scheme Short Term Capital Gains Tax Long Term Capital Gains Tax
Equity funds 15% 10%*
Debt Funds The Income Tax Slab Rate of the Investor 20% after indexation

What Happens to Dividends?

  1. Equity mutual funds: The dividend earned used to be completely tax-free until Budget 2018. This has been increased to 10% from April 1, 2018, in line with the long term capital gains tax applied on equity mutual funds in the 2018–19 budget.
  2. Debt funds: Your dividend income from debt funds is also tax-free in your hands, but the Mutual Fund house has to pay tax before distributing the dividend to you. This tax is called a dividend distribution tax (DDT). The dividend distribution tax on debt funds is set at 28.84%.

What Happens to Capital Gains Tax after the 2018–19 Budget?

With the Budget of 2018–19, the tax for long term capital gains on equity mutual funds moved from 0% to 10%. This applies if your gains are over Rs 1 lakh in a year and do not bring any indexation benefit with it. However, any long term capital gain before January 31, 2018, will not be taxed.

For instance, if you bought units in an equity Mutual Fund on July 31, 2017, and you made a gain of 15% till January 31, 2018. If you redeem this Mutual Fund on July 31, 2018, you will pay long term capital gains tax on only the gains after January 31, 2018.

How to reduce tax liability

Whilst the best way to save on capital taxes is to hold out for the long term no matter what kind of fund you invest in, you can reduce your tax burden by investing in ELSS or tax saving Mutual Funds. ELSS funds can help reduce your taxable income by an amount up to ₹1,50,000 in a financial year under 80C. Depending on the tax slab that you are in, it could help reduce your taxes by up to ₹46,800. You can find some of the best tax saving mutual funds which will not only help you save taxes but also help in wealth creation.