Setting off of Capital Gains and Losses under Income Tax Act

Capital gain is the profit earned on the transfer of a capital asset, whereas capital loss is the loss incurred on such a transfer. Under Section 70 of the Income Tax Act, a loss can be set off only against a profit of the same head (i.e., capital loss against capital gain).

Capital assets are classified based on the period of holding. If the asset is held for 36 months or less (24 months for listed equity shares and equity‑oriented mutual funds), the gain/loss is short‑term. Holding beyond this period creates a long‑term gain or loss. The distinction matters because the tax rates differ and the set‑off rules treat them separately.

For the NISM exam, remember that set‑off is allowed only within the same assessment year (AY). Any loss that cannot be absorbed in that AY may be carried forward, subject to filing the income tax return before the due date.

• Capital gains and losses are part of the “Capital Gains” head in the income tax return.
• The set‑off provisions are independent of SEBI regulations; they are purely tax‑law concepts.

The Income Tax Act prescribes a specific sequence for setting off capital losses against gains. The order is:

1. Short‑term capital loss (STCL) is first set off against short‑term capital gain (STCG).
2. If any STCL remains, it is then set off against long‑term capital gain (LTCG).
3. Long‑term capital loss (LTCL) can be set off only against LTCG; it cannot be used against STCG.

This hierarchy ensures that losses are utilised in the most tax‑efficient manner. For example, because STCG is taxed at the investor’s slab rate (often higher than the 10% LTCG rate), using STCL against STCG reduces a higher tax liability.

Exam relevance: Many NISM questions present a table of gains and losses and ask for the net taxable capital gain after applying the correct set‑off order. Missing the sequence leads to an incorrect answer.

For a loss to be set off, both the loss and the gain must arise in the same assessment year. The loss cannot be set off against income under any other head such as salary, house property, or business.

The loss and gain must also belong to the same category of capital asset for the purpose of classification (e.g., both from listed equity shares, or both from debt mutual funds). However, the law permits cross‑category set‑off between short‑term losses and long‑term gains irrespective of the asset class.

Practically, this means that an investor who incurs a short‑term loss on a debt fund can still use that loss to reduce a long‑term gain on an equity fund, provided both occur in the same AY.

Exam tip: Look for the phrase “same assessment year” in the question stem – if the years differ, set‑off is not allowed and the loss must be carried forward.

If after applying the set‑off order a portion of STCL or LTCL remains unabsorbed, the loss can be carried forward for a maximum of eight assessment years. The carried‑forward loss can be set off only against the same type of gain in future years (STCL against STCG, LTCL against LTCG).

The taxpayer must file the income tax return before the due date (including extensions) for the AY in which the loss arose. Failure to do so results in the loss being disallowed for carry‑forward.

For mutual fund distributors, it is important to advise clients to file returns promptly, especially when the client has a large capital loss that they intend to use in future years.

Short‑term capital gains are taxed at the investor’s applicable income‑tax slab rate, which can be as high as 30% plus surcharge and cess. Long‑term capital gains on listed equity shares and equity‑oriented mutual funds enjoy a concessional rate of 10% (plus cess) after an exemption of Rs. 1 lakh per AY.

When a short‑term loss is set off against a short‑term gain, the reduction occurs at the higher slab rate, providing greater tax savings. Conversely, a long‑term loss set off against a long‑term gain reduces tax at the 10% rate only.

Exam tip: Always compute the net gain first using the set‑off rules, then apply the appropriate tax rate. Forgetting the Rs. 1 lakh LTCG exemption is a common mistake.

1. Mixing loss types – Using LTCL against STCG is not permitted. 2. Ignoring assessment year – Set‑off is allowed only within the same AY; losses from a previous year must be carried forward. 3. Overlooking the LTCG exemption – Many candidates subtract the exemption before set‑off, which reverses the correct order. 4. Assuming all losses can be set off – If the loss exceeds the gain of the same type, the excess must be carried forward, not written off. 5. Failing to file the return on time – Untimely filing disqualifies the loss from being carried forward.

By checking each of these points while solving a problem, you can avoid the typical pitfalls that lead to wrong answers in the exam.

Remember the mnemonic "S‑L‑L‑S" for set‑off order: Short‑term loss → Long‑term gain, then Long‑term loss → Short‑term gain is NOT allowed. In practice, the sequence is STCL → STCG → STCL → LTCG → LTCL → LTCG.

This short cue helps you quickly write the correct order during the exam.