If you have run up losses in stocks in the market downturn, here's how you can use them to bring down your tax burden

It's a sea of red out there. The Nifty has lost almost 8% in the past 3 months. Even index-based blue chips are trading 30-35% below their 52-week highs. Should you cut your losses or wait for the tide to turn? Selling stocks at a loss is never an easy decision. However, painful as it may be, booking losses could be a smart move for investors wanting to reduce their tax burden.

Here's how it works. You sell the stocks in your portfolio to book losses and then buy back the same stocks the next day. Any loss you make on stocks or equity funds bought less than 12 months ago can be adjusted against gains from certain other investments, including short-term capital gains from stocks and equity funds as well as long-term gains from debt funds and gold ETFs and jewellery. What's more, the unadjusted losses can be carried forward for up to eight financial years.

This doesn't mean that investors should rush out and dump all their loss-making stocks only to book tax losses. Before you embark check when you bought the stocks that are now trading at a loss. Only short-term capital losses from stocks can be adjusted against other gains or carried forward.

Also remember that the sale of stocks and funds is on a first-in-first-out basis. This means the shares you bought first will be deemed to have been sold first. Suppose you bought 500 shares of a company at 150 each in January 2011 and then another 500 at 180 in July 2011. If you sell 500 of those shares at 140 now, you will not be allowed to carry forward the loss because your holding period of the intial tranche of 500 shares has exceeded one year. It is now a long-term capital loss. Since there is no tax on long-term capital gains from stocks, there is also no provision to carry forward the long-term capital losses from this asset class.
Chartered accountant It is possible to carry forward long-term capital losses from stocks if the seller strikes an off-market deal with the buyer and the transaction is not routed through a stock exchange. However, it is difficult to find a buyer who agrees to such a deal. Besides, long term capital losses can be set off only against long-term capital gains.

What are the risks involved?

Selling at a loss involves a risk. What if the stock price shoots up after you have sold? If your intention was to hold the stocks for the long term, you might have to shell out a higher price the next day. To avoid this risk, you can buy more of the stock and then sell them the next day. Under the first-in-first-out rule, it will be deemed that you have sold the shares you bought earlier.

But this strategy is also risky. If the share price falls further the next day, your losses will amplify. Some investors may want to take the upside risk and sell before they buy back the shares. Others may be more comfortable with the downside risk that entails buying more before they sell.

One way to avoid such a risk is to buy and sell your holdings in small quantities. If you have 1,000 shares of a stock in which you want to book losses, spread out your buying and selling in tranches of 100 shares over a period of 10-12 days. Sell 100 one day, then buy them back the next day. Repeat this till you have sold and bought back the entire lot. This way, you can contain the upside and downside risk to just 100-200 shares.

Taking delivery is important

When you go about selling and buying back, take care not to conduct both transactions on the same day. When you do that, you don't actually take delivery of the stocks. Such intraday transactions are treated as speculative by the taxman and can be disputed by the tax department if you want to book losses. In some countries, such as the US, if a taxpayer wants to book losses, there should be a 30-day gap between the sale and subsequent purchase of shares. Though there is no such rule in India, it is best to wait for a day or two before you buy back the shares so that the shares bought previously are out of your demat account before the new shares come in.

Keep the contract notes of the transactions handy. You may need to mention the details of the transactions in the tax form when you file your income tax returns.