Reading your mutual fund portfolio through a tax lens

Mutual fund investing has become almost effortless. SIPs, redemptions and switches can now be done in a few clicks. But when return filing season begins, many investors discover an uncomfortable truth: investing has become simple, taxation has not.

A common blind spot is the tax impact of switching between schemes. Many investors move from one fund to another, or from a regular plan to a direct plan, believing that no tax event has occurred because the money has not come into their bank account. In tax law, a switch is treated as redemption from one scheme and fresh investment into another. The first leg can trigger capital gains, even within the same fund house. Systematic Transfer Plans work the same way; each instalment is a transfer.

Gifting of mutual fund units within the family has its own logic. A gift from close family, such as spouse, parents, children and certain lineal relatives, is not taxed at the time of gift. But the story is only postponed. When the recipient redeems the units, the donor’s original cost becomes the recipient’s cost, and the donor’s holding period is also counted for, determining whether the gain is short term or long term. A daughter who redeems units gifted by her father does not take market value on the date of gift as her cost. She steps into his shoes.

For listed equity shares and equity-oriented mutual funds, where STT is paid on sale, the structure for FY2025-26 is settled. Short-term gains, holding up to 12 months, are taxed under Section 111A at 20%. Long-term gains, holding more than 12 months, are taxed under Section 112A at 12.5%, but only on the portion exceeding Rs 1.25 lakh per financial year, aggregated across all such transactions. Surcharge is capped at 15%, cess at 4% applies.

This last point is important. The popular notion that there is no tax up to Rs 12 lakh of income under the new regime does not extend to special rate capital gains. A resident may still claim the basic exemption limit where available, but Section 87A rebate cannot wipe out tax on Section 112A gains.

The Rs 1.25 lakh annual exemption is the most-underused planning tool in retail portfolios. Redeeming and reinvesting units sitting on gains within the threshold resets the cost base; the exempt portion is locked in permanently. The mirror exercise on loss-making units allows set-off against other capital gains in the same year, with any unutilised long-term loss available only against future long-term gains. Exit load, STT, stamp duty, brokerage, market movement and the merit of the fund must be weighed before the calculator decides.

Debt funds carry the largest pocket of confusion. Section 50AA covers mutual funds investing more than 65% in debt and money market instruments, and also funds investing 65% or more in such debt-oriented funds. Units bought on or after April 1, 2023, are taxed at slab rate, irrespective of holding period, with no LTCG concession and no indexation

The return form is the next trap. For AY 2026-27, ITR 1 permits LTCG under Section 112A up to Rs 1.25 lakh, subject to conditions. But a single rupee of short-term gain, any LTCG above the threshold, capital loss to be carried forward, debt fund gain under Section 50AA, foreign assets or unlisted shares pushes the filing to ITR 2. The wrong form invites a defective return notice and delays refunds.

Two procedural points are critical. Capital losses can be carried forward for eight assessment years only if the return is filed within the due date under Section 139(1). Also, with mutual fund redemptions now reflected in AIS, taxpayers should reconcile AIS with registrar capital gains statements and broker reports before filing. It is far-easier than explaining a mismatch notice later.

Post tax return is the only return an investor actually keeps. A good investor asks not only how much was earned, but how much will be kept.

B E Kumar Prasad Chartered Accountant & Partner, Balakrishna and Co