What is FIFO in Demat? Mutual Fund Investors Must Know This Before Filing Their Taxes

Filing taxes on capital market investments is not only about reporting your income but also about how you compute it. For mutual fund investors in India, one technical aspect that often goes unnoticed until tax season is FIFO (First-In, First-Out) treatment in Demat accounts. While this concept may seem simple, its implications for taxation, capital gains categorisation, and compliance under the Income-tax Act, 1961, are far-reaching.

This article provides an advanced analysis of FIFO accounting in Demat accounts, its relevance for mutual fund investors, the tax nuances attached to it, and practical strategies to manage compliance effectively.

Invest in Indian Markets and Unlock Future Potential With 5paisa!

Open Account Now

Why FIFO Matters in the Indian Market Context

Mutual funds are popular investment vehicles in India, held either in Demat form or in Statement of Account (SoA) mode through registrars. While most retail investors think of their units as fungible, the income tax rules do not. The order in which you acquire and redeem units directly determines the holding period, which in turn defines whether the gain is short-term or long-term.

• Short-Term Capital Gains (STCG): Units held for less than 12 months in equity-oriented schemes (or 36 months for debt schemes).
• Long-Term Capital Gains (LTCG): Units held beyond the threshold of 12 months.

FIFO comes into play because when you redeem, the system assumes that your oldest units are sold first, irrespective of which folio, batch, or price you mentally associate them with.

This treatment ensures standardisation and prevents taxpayers from cherry-picking lots to reduce tax liability, which could otherwise distort tax revenues.

FIFO and Demat: How It Is Applied

When mutual fund units are held in Demat mode, depositories (NSDL/CDSL) apply FIFO to determine which units are debited upon redemption or switch. Let’s illustrate:

• Suppose you bought 100 units of an equity mutual fund in April 2023 at ₹100 NAV.
• You bought another 100 units in December 2023 at ₹120 NAV.
• In March 2024, you redeemed 120 units.

Under FIFO:

• The first 100 units sold will be from the April 2023 lot.
• The next 20 units will be from the December 2023 lot.

Thus, your tax computation will differ, as the April units may qualify for LTCG by April 2024, but the December lot will still fall under STCG.
This FIFO determination becomes particularly important when reporting Schedule CG in the Income-tax Return (ITR), since you cannot arbitrarily allocate which purchase to link against a sale.

Why FIFO Impacts Mutual Fund Taxation

Classification of Gains

FIFO determines the holding period clock, which then defines the rate of tax:

• Equity schemes: STCG at 20%, LTCG at 12.5% (above ₹1.25 lakh exemption).
• Debt schemes: Taxed as per individual income slab rate (if held pre-April 2023 rules; post-April 2023, indexation withdrawn for debt mutual funds).

Affecting Tax Optimisation Strategies

Investors often try to redeem newer units first to avoid STCG. FIFO eliminates this choice. For example, redeeming even one unit could unexpectedly trigger a taxable STCG component if earlier acquisitions fall within the short-term window.

Impact on Dividend Reinvestment and SIPs

• Systematic Investment Plans (SIPs): Each SIP instalment is a new acquisition date. When redeemed, FIFO takes the oldest SIP units first, not the most recent.
• Dividend Reinvestment Plans: New units allotted through reinvested dividends are treated as separate purchases and enter the FIFO queue.

This means investors with regular SIPs or reinvestment plans may face a complex mix of STCG and LTCG on redemption, even if they redeem in a lump sum.

Advanced Pitfalls: Where Investors Slip

1. Misreporting in ITRs
Many taxpayers wrongly assume they can choose which batch of units to sell, leading to underreporting or incorrect classification of capital gains. Tax authorities cross-check with depository data, and mismatches can trigger scrutiny.

2. Corporate Actions
Events such as bonus issues, mergers, or scheme consolidations can complicate the FIFO chain. The new units carry forward the holding period of original units, but many investors misinterpret this, resulting in wrong capital gains computation.

3. Redemption for Specific Goals
Suppose you want to withdraw only the latest SIP instalments (say, for liquidity). In practice, FIFO will debit older units first, possibly triggering unwanted STCG and increasing your immediate tax liability.

Legal and Regulatory Backing

FIFO treatment is not arbitrary but has firm legal grounding:

• CBDT Circular No. 704 (1995): Clarifies that in the case of securities, the FIFO method applies to determine which asset is transferred.
• Depositories Act, 1996: Depositories treat securities as fungible, but FIFO is applied for capital gains identification.
• Income-tax Act, 1961: Requires accurate reporting of cost and holding period; FIFO is the default methodology accepted by both IT authorities and depositories.

Thus, when filing returns, you are legally bound to follow FIFO for all capital gains calculations.

Practical Examples for Mutual Fund Investors

Example 1 – Equity Mutual Fund SIP

• April 2022: 50 units @ ₹100 NAV
• June 2022: 50 units @ ₹110 NAV
• September 2022: 50 units @ ₹120 NAV
• Redemption in June 2023: 100 units

FIFO dictates:

• First 50 units from the April 2022 lot – LTCG.
• Next 50 units from the June 2022 lot – STCG.

Thus, redemption yields a split liability, despite redeeming in one transaction.

Example 2 – Debt Fund under Post-April 2023 Rules

• May 2023: 1,000 units of a debt scheme @ ₹10 NAV
• December 2023: 500 units @ ₹11 NAV
• Redemption in April 2024: 800 units

FIFO applies:

• 800 units entirely from the May 2023 purchase.
• Since held <36 months but post-rule change, gains are taxed at individual slab rates (without indexation benefit).

Strategies to Manage FIFO Effectively

• Folio Segregation: Maintain separate folios for long-term and short-term investments. Though FIFO applies within each folio, it gives you more control over redemptions.
• Redeem in Tranches: If you wish to avoid STCG, time your redemptions to ensure older units qualify as long-term.
• Tax-Loss Harvesting: Use market dips to redeem and book losses, which can offset gains elsewhere. FIFO ensures older high-cost units are realised first, aiding tax optimisation.
• Use Portfolio Tracking Tools: Advanced platforms integrated with CAMS/KFintech provide FIFO-based tax statements. Using these reduces the risk of errors at the time of filing.

Conclusion

For Indian mutual fund investors, FIFO in Demat accounts is not just an accounting principle but a tax law requirement. It governs how gains are computed, how holding periods are classified, and ultimately, how much tax you pay. With the growing complexity of SIPs, dividend reinvestments, and changing tax rules (such as debt fund indexation removal), FIFO’s role has become even more significant.
Investors must not overlook its impact when planning redemptions.

Accurate tax reporting, supported by FIFO-based statements from depositories or R&T agents, is crucial for compliance and avoiding disputes with the tax department. As the Indian tax regime becomes more data-driven, understanding and applying FIFO correctly is no longer optional—it is essential for every serious mutual fund investor.