Loss in Mutual Funds: Types of Losses and How Are They Treated for Tax?

Investing in mutual funds doesn’t always mean profits. Markets move in cycles, and at times, investors do face a loss in mutual fund investments. While losses can feel discouraging, from a tax perspective, they aren’t entirely negative. In fact, understanding how different mutual fund losses are treated can help you plan better and reduce your overall tax burden.

Broadly, mutual fund losses fall under capital losses. The mutual fund loss tax treatment depends on the type of fund and how long you held it. Equity mutual funds and debt mutual funds follow different rules, so it is important to consider these two as entirely different before taking a look at tax implications.

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When you sell mutual fund units at a price lower than your purchase cost, it results in a capital loss on mutual funds. If equity mutual funds are sold within one year, the loss is treated as a short term capital loss. Holding them for more than a year leads to a long term capital loss. The same logic applies to debt funds, although the holding period thresholds differ.

The advantage becomes clearer when you understand how to set off mutual fund losses against gains. Short term capital loss can be adjusted against both short-term and long term capital gains. On the other hand, a long term capital loss mutual fund can only be set off against long term capital gains. Even if you don’t have gains in the same year, these losses aren’t wasted, you can carry them forward and use them in future years.

Investors have the benefit of carrying over unused losses from previous tax years to offset any gains in future years under current tax law (which allows them to do this for 8 years after the year of loss). This can be extremely advantageous for those whose portfolios fluctuate significantly over time. Although experiencing a loss on your investment in a mutual fund might create an emotional reaction, keep in mind that this loss also creates opportunity from a tax planning standpoint. If you understand how capital loss rules apply, you will be able to understand market downturns and make better long-term financial decisions when investing your resources.