Prior to April 2023, if you held debt mutual funds for more than three years, the gains were considered long-term and taxed at 20% after applying the indexation benefit.
If you invested in debt mutual funds before April 1, 2023, there’s important information you should be aware of. The government has made changes to the way capital gains from these investments are taxed.
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This change, which took effect from April 1, 2023, removed the indexation benefit for calculating tax on long-term capital gains from debt mutual funds.
As a result, any capital gains arising from the sale of debt mutual funds are now taxable at the income tax slab rate applicable to your income.
Prior to April 2023, if you held debt mutual funds for more than three years, the gains were considered long-term and taxed at 20% after applying the indexation benefit.
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Indexation adjusts the purchase price of an asset using the Cost Inflation Index (CII), reducing the taxable gain and lowering your tax liability.
This benefit is now no longer available for debt mutual funds purchased on or after April 1, 2023. From this date, all capital gains on debt mutual funds, regardless of the holding period, are treated as short-term and taxed according to your income tax slab rate.
However, if you invested in debt mutual funds before April 1, 2023, your gains still qualify as long-term capital gains (LTCG) and can be taxed at 20% with the indexation benefit, as long as you sell these investments before July 23, 2024.
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Changes from July 2024
In the July 2024 budget, the government rationalised the capital gains taxation regime. From July 23, 2024, LTCG from selling assets, including listed and unlisted securities, are taxable at 12.5% without the indexation benefit.
However, for debt mutual funds, the situation is different. Gains from debt mutual funds will still be taxed at the income tax slab rate, not the new LTCG rate of 12.5%. This raises the question of how capital gains from debt mutual funds bought before April 1, 2023, will be taxed if sold after July 23, 2024.
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Neeraj Agarwala, Partner at Nangia & Co LLP, a tax consulting firm, told The Economic Times (ET) that capital gains from debt mutual funds bought on or before March 31, 2023, which were previously taxed as long-term gains at 20% with indexation, will now be taxed at 12.5% without indexation.
“The new LTCG tax rate will apply to transfers, maturities, or redemptions made on or after July 23, 2024. But remember, there is no change in the tax rules for debt mutual funds bought on or after April 1, 2023; these will still be taxed as short-term gains,” he said.
Punit Shah, Partner at Dhruva Advisors, told ET that long-term capital gains from debt mutual funds bought before April 1, 2023, will now be taxed at 12.5% without indexation.
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“The change in LTCG tax rules will affect investors who had planned to benefit from indexation. It’s important to check the type of debt mutual fund (listed or unlisted) before redeeming them, as the holding period for classifying gains as long-term has been reduced from 36 months to 12 months for listed securities and 24 months for unlisted,” he added.
How will this impact your investments?
For debt mutual funds bought before April 1, 2023, the LTCG tax rate has been reduced from 20% to 12.5%, but the indexation benefit is no longer available. This could potentially increase your tax liability, as the earlier system allowed you to adjust the purchase price using indexation, which could lower the taxable gain.
Agarwala said, “The impact of removing the indexation benefit will depend largely on the annualised return from the debt fund. If the return is close to the average increase in the Cost Inflation Index (CII), around 7% to 9%, the old system of 20% tax with indexation would have been more beneficial. However, if the return is significantly higher, around 12%, the new system of 12.5% tax without indexation might be more advantageous.”
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Types of debt mutual funds
Debt mutual funds come in various types, each offering different returns depending on the securities they invest in. For example, overnight funds invest in bonds with one-day maturity, medium-duration funds invest in bonds with a maturity of three to four years, and long-duration funds invest in bonds with a maturity of more than seven years.
The returns from these funds can vary significantly. Long-duration funds, while potentially offering higher returns, also come with higher risks, including interest rate risk and credit risk. Shorter-duration funds are generally less risky but offer lower returns.
What about losses?
The government’s revision of LTCG tax rules also impacts how losses from debt mutual funds are handled. If you incur a loss on the redemption of debt mutual funds bought before April 1, 2023, the rules for carrying forward and setting off these losses remain the same. Losses can be carried forward for eight financial years and can be set off against capital gains from other assets.
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“Losses from the sale of debt mutual funds bought before April 1, 2023, can be set off against gains from other assets according to the nature of the loss. Long-term capital losses can be set off against long-term gains, and short-term losses can be set off against both short-term and long-term gains. However, for debt mutual funds bought on or after April 1, 2023, losses will qualify as short-term and can be set off against any capital gains without the indexation benefit,” said Shah.
