Adjusting losses can be taxing --- Sandeep Shanbhag

Tuesday, 10 April 2007 

Now that the financial year has come to an end, it is time to start preparing for filing of tax returns.

One very important aspect of the process of filing returns is the adjustment of losses. If such loss cannot be fully set off, the balance can even be carried forward for set-off in future years. It is necessary for every taxpayer to properly understand and take advantage of the facilities in this regard as this will enable the tax return to be optimised for minimum tax payment.

Inter-source adjustment

There are five heads of income under which any taxpayer can earn income - salary, house property, income from business or profession, capital gains and the residuary income from other sources. By definition, there cannot be a loss from salary and income from other sources. However, a person could suffer losses from other heads of income.

The first and foremost rule is that loss under one head of income has to be first adjusted against any income from the same head.

This is known as inter-source adjustment.

For example, say someone has two different businesses - one of which is loss-making, while the other makes profit. The loss from the first business can be set off against the profit from the second one.

Or, say you have two properties - one for self-occupation and the other one given out on rent. The loss from the first property (on account of the mortgage interest) can be set off against the rental income from the second property. The only exception in this regard has to do with long-term capital gains (LTCG).

Inter-head adjustment

Now, say after setting off the loss as above, there still remains some balance; this loss can then be set off against income from other heads. This is known as inter-head adjustment. For example, a taxpayer who has a single self-occupied house property bought on mortgage will necessarily show a loss. This is because the annual value of a single self-occupied property is taken to be nil and the adjustment of any interest will result in a negative value.

Now, such a loss may be adjusted against salary income or say income from business, if any. There are two exceptions to the rule of inter-head adjustment — losses under capital gains cannot be set off against income from any other head.

Loss from business or profession cannot be set off against salary income.

Carry forward of losses

Any loss that cannot be set off either against the same head or under other heads, because of inadequacy of income, may be carried forward to be set off against income of the subsequent year. Such a carry forward exercise may be done for 8 years after which, if the loss hasn’t yet been fully set off, it has to be written off and cannot be used for tax saving. The important point to note is that for carry forward losses, only inter-source adjustment is available in the subsequent years and not the inter-head one.

Adjustment of loss under the head capital gains

The first and foremost point to note about losses under the head capital gains is that they have a boundary, i.e., they have to be adjusted against other capital gain income only and other incomes are not available for the setting off. In other words, the inter-head adjustment referred to earlier is not available in the case of capital losses.

The second condition in this regard is that long-term capital loss (LTCL) can only be adjusted against long-term capital gain. Or putting it differently, short-term capital gain (STCG) may not be used to set off any long-term capital loss. However, short-term capital loss (STCL) can be set off against any taxable long-term capital gain or short-term capital gain.

In a nutshell, long-term capital loss adjustment can be only done against long-term capital gains, whereas short-term capital loss adjustment can be against any capital gains, long-term or short-term.

Lastly, if the income from a particular source is exempted from tax, loss from such a source cannot be set off. This means, any long-term loss on sale of shares or equity-oriented mutual funds cannot be set off at all as the long-term gain from the sale of these instruments is exempted. In other words, loss of profits must be a loss of taxable profits. Take the following example:

Now, LTCL from shares cannot be set off since the LTCG from this source (in this case Rs 60,000) is exempted. The LTCL from non-equity MFs of Rs 30,000 can only be adjusted against the LTCG from sale of gold. Therefore, only Rs 15,000 can be adjusted and the balance Rs 10,000 will be non-adjustable. Lastly, the Rs 40,000 STCL from sale of shares can be adjusted against the Rs 50,000 STCG and only the balance Rs 10,000 STCG would be taxable.

http://www.dnaindia.com/money/report-adjusting-losses-can-be-taxing-1090030