Tax-Loss Harvesting Using Mutual Funds — Strategy and Pitfalls

Tax-loss harvesting is one of the few genuinely proactive, entirely legal levers an ordinary mutual fund investor has to reduce their tax bill — and it works especially well alongside the ₹1.25 lakh annual equity LTCG exemption, which quietly resets every financial year whether or not an investor actually uses it. Done carelessly, though, it collides directly with two specific anti-avoidance provisions built precisely to catch loss-harvesting-style transactions.

The Core Strategy — Using an Exemption That Otherwise Goes to Waste

The ₹1.25 lakh annual exemption on equity long-term capital gains under Section 112A is a use-it-or-lose-it allowance — it does not carry forward if unused in a given year. An investor sitting on unrealised equity fund gains, with no other capital gains event planned for the year, is simply leaving this exemption on the table by doing nothing. The basic harvesting strategy is straightforward: redeem enough long-term equity fund units to realise gains up to (but not exceeding) the ₹1.25 lakh threshold, pay zero tax on that realised gain, and — if the intention is to remain invested — immediately reinvest the proceeds into the same or a similar fund, effectively resetting the cost base higher at no tax cost.

Why Resetting the Cost Base Matters Beyond the Current Year

Harvesting the exemption annually does more than save tax in the year it's done — it raises the investor's cost basis for the reinvested units, which reduces the future taxable gain when those units are eventually sold for good. An investor who harvests ₹1.25 lakh in gains every year for a decade, reinvesting each time, ends up with a materially higher cost base on their holding than one who never harvests at all — converting what would eventually be one large, partly-taxable gain into a series of smaller, fully tax-free ones spread across years.

Using Losses Deliberately — Booking a Loss Before Year-End

The mirror-image strategy applies to positions genuinely sitting at a loss: rather than simply holding a loss-making fund indefinitely, an investor can deliberately redeem it before the financial year-end to crystallise the loss, use it to offset other realised gains in the same year (subject to the short-term/long-term matching rules covered in our companion article on set-off and carry-forward), and — if they still believe in the fund's prospects — reinvest in the same or a similar scheme afterward.

Dividend Stripping — Section 94(7) and Why It Specifically Targets This Strategy

A specific and easily-triggered trap sits around funds that are about to make an IDCW distribution. Section 94(7) disallows a capital loss where an investor buys mutual fund units within three months before the record date, sells them within nine months after the record date, and the income/distribution received on those units was exempt from tax — with the loss disallowed only up to the amount of that exempt income. Because IDCW is now taxable at slab rate for nearly all resident investors (following the 2020 abolition of DDT), the specific "exempt income" trigger condition is met far less often today than when dividends were tax-free — but the provision remains live for cases where it does apply, and investors deliberately timing a purchase around a distribution date specifically to harvest a subsequent loss should check this condition carefully before assuming the loss will be fully allowed.

Bonus Stripping — Section 94(8) and a Trap That's Easier to Fall Into by Accident

Section 94(8) is the more commonly relevant provision for mutual fund investors today, and it applies regardless of whether IDCW is taxable. Where an investor buys units within three months before the record date for a bonus unit issue, and sells the original units within nine months after that record date, any loss on the sale of the original units is disallowed entirely — and, since a 2022 amendment, that disallowed loss is instead added to the cost of acquisition of the bonus units received, rather than simply vanishing. This provision was specifically introduced to shut down a once-popular strategy: buying before a bonus issue, immediately booking a "loss" on the diluted original units (since a bonus issue mechanically halves the per-unit price in a 1:1 issue), while retaining the bonus units to eventually sell at a lower long-term tax rate. Since the 2022 amendment, this specific structure no longer works — the "loss" is simply deferred into a higher cost base on the bonus units rather than being usable immediately.

Why This Matters More for Debt and Hybrid Funds That Still Issue Bonuses

Bonus unit issues are less common in mainstream equity funds today but do still occur, particularly in some debt and hybrid schemes as a structuring mechanism. Any investor tax-loss harvesting around a scheme that has recently announced or is expected to announce a bonus issue should specifically check the record date and their own purchase timing against the Section 94(8) window before assuming a resulting loss will be usable.

Practical Discipline for Harvesting Without Tripping Either Provision

The safest and most common way to avoid both traps entirely is to harvest losses (and gains) on funds with no pending distribution or bonus issue in the relevant window, and to avoid buying back into the exact same scheme immediately after booking a loss if a distribution or bonus record date falls within the following nine months — switching instead to a similar but distinct scheme achieves the same portfolio continuity without walking into either provision's specific purchase-and-sale timing test.

There Is No General "Wash Sale" Rule in India — But These Two Provisions Function Similarly

Unlike some other jurisdictions, India does not have a broad, general anti-wash-sale rule prohibiting an investor from selling an asset at a loss and immediately repurchasing the identical asset to preserve the position while claiming the loss. Sections 94(7) and 94(8) are the specific, narrower mechanisms that exist instead — targeted precisely at the dividend-timing and bonus-timing scenarios described above, rather than a blanket prohibition on buy-back-immediately-after-a-loss transactions generally.

Building a Harvesting Plan That Actually Survives Scrutiny

Tax-loss harvesting is a legitimate, valuable strategy, but only when executed with the specific timing traps under Sections 94(7) and 94(8) in mind, and reconciled correctly against the set-off and carry-forward rules covered in our companion article. We help investors build an annual harvesting plan — both for realising gains within the exemption and for booking legitimate losses — that captures the full benefit without inadvertently triggering either anti-avoidance provision.

This article reflects the law as understood at the time of writing for FY 2026-27 (AY 2027-28) and is for general informational purposes only. It does not constitute tax advice specific to any individual's circumstances — please consult a qualified Chartered Accountant before executing a loss-harvesting transaction.