LTCG tax relief for these mutual fund investors proposed by SEBI; know how switching funds for portfolio rebalancing can save tax

The Securities and Exchange Board of India (SEBI) has also proposed tax relief for domestic mutual fund investors, suggesting they be exempt from LTCG if they are selling existing holdings to invest in new ones, as per an ET report. This is a pre-budget proposal from SEBI to the government and experts say if this is implemented then it can help Indian mutual funds investors potentially generate more returns from their investments.

At present, if a mutual fund is sold after 12 months it attracts 12.5% long term capital gain tax and if sold before 12 months then 20% short term capital gains tax. However, this tax is not just for selling but even for switching from one fund to another. For example: You have Rs 10 lakh invested in a small cap mutual fund and want to switch to a large cap mutual fund after 13 months, so 12.5% LTCG tax applies at the time of switch. Experts say that for rebalancing a portfolio individuals need to switch funds at specifically planned intervals and taxing such switches increases the cost and reduces the potential returns.

Also read: Sebi backs removal of LTCG tax for foreign investors: Report

How may this proposal help mutual funds investors?

Here’s a summary of how the proposal could help MF investors:

Removing tax cost of a mutual fund portfolio rebalancing

CA Avinash Kumar Rao, Partner at Mohindra & Associates said to ET Wealth Online that at present switching from one mutual fund scheme to another is treated as redemption of the existing investment and a fresh purchase. This triggers capital gains tax (long term or short term depending on the holding period), even though the investor may not have actually withdrawn any money for personal use.

For instance, an investor who invested Rs 10 lakh in a mutual fund, which has now appreciated to Rs 15 lakh, may want to move to another scheme because of its performance, investment strategy or changing financial goals or due to portfolio rebalancing requirements. However, the switch could trigger capital gains tax on the Rs 5 lakh appreciation, despite the investor continuing to remain invested in mutual funds.

Rao says: “If the proposal is implemented, investors could rebalance their portfolios or move between eligible schemes without an immediate tax liability. This would allow the entire investment value to remain invested and continue compounding.”

Rao says that this is a sensible proposal because taxation should ideally not discourage investors from making appropriate portfolio allocation decisions, particularly when they are not exiting the investment ecosystem altogether.

Suresh Sadagopan, founder, Ladder7 Financial Advisories said toET Wealth Online says: "Investors pay capital gains tax both at the time of switching between funds and redemption and this lowers the net earnings from the investment. So removing this tax helps investors get more earnings and at the same time it means less tax revenue for the government especially at a time when the external environment is not supportive and government needs to step in to support which will impact the fiscal deficit."

Chartered Accountant Suresh Surana says that the proposed tax relief could facilitate tax-efficient portfolio rebalancing, enable investors to shift from underperforming mutual funds to better-performing alternatives, and encourage long-term investments by allowing a larger portion of their mutual funds to remain invested and benefit from compounding.

Here's a table showing the current mutual fund taxation framework for both LTCG and STCG:

Mutual Fund / ETF category	STCG holding period	STCG tax rate	LTCG holding period	LTCG tax rate
Equity Mutual Fund	Up to 12 months	20%	More than 12 months	12.5% on aggregate LTCG exceeding Rs. 1.25 lakh
Hybrid Fund with equity exposure below the equity-oriented threshold, but not qualifying as a Specified Mutual Fund	Up to 24 months	Applicable slab rate	More than 24 months	12.5% without indexation
Specified Mutual Fund investing predominantly in debt and money-market instruments	Irrespective of holding period always short – term capital gains and taxable at the applicable slab rates
Gold / Silver ETFs	Up to 12 months	Applicable slab rate	More than 12 months	12.5% without indexation
Funds of Funds (FoF) qualifying as an equity-oriented fund under the special statutory conditions	Up to 12 months	20%	More than 12 months	12.5% on aggregate LTCG exceeding Rs. 1.25 lakh

The above tax rates exclude applicable surcharge and 4% Health and Education Cess.

Source: CA Suresh Surana

Sadagopan also says this proposal from SEBI to remove LTCG while redeeming mutual fund investments would be a big positive for investors but it looks very difficult for the government to implement it as one one side crude prices are climbing up, petrochemical inputs are becoming expensive and due to deficit rainfall government may have to support agriculture sector in various ways.

Potential benefits for older mutual funds' cost of acquisition

Chartered Accountant Suresh Surana says that an important aspect would be the treatment of the cost of acquisition of the new mutual fund units. For instance, where an investment of Rs 10 lakh have appreciated to Rs.18 lakhs, an investor could potentially redeem and reinvest the entire Rs 18 lakh without paying LTCG tax on the accrued gain of Rs 8 lakh.

If the proposed framework also permits a step-up in the cost of acquisition to Rs 18 lakh, Surana says that any subsequent capital gains would be calculated with reference to this revised cost, providing an additional tax advantage. However, if the mechanism merely defers taxation and requires the original cost of Rs 10 lakh to be carried forward, the accrued gains could become taxable upon subsequent redemption.

A shorter reinvestment proposal for getting LTCG tax exemption is needed for the scheme to work

Experts say that the present proposal can differ significantly from Section 54/54F of Income Tax Act, 1961. At present if you sell a residential property and reinvest the gains from this sale to buy another residential property then you can claim a tax exemption.

Mihir Tanna, associate director, S.K Patodia LLP says that if the Ministry of Finance accepts SEBI's recommendation to grant LTCG tax relief when selling equity holdings to reinvest in new ones, the rules governing the reinvestment period will differ significantly from Section 54F of Income Tax Act 1961 due to the several factors.

Tanna says that Section 54 operates in the property domain where each transaction requires title searches, legal due diligence, registration, and physical possession, justifying extended time limits. However, equity markets operate on automated electronic trading platforms with rapid settlement cycles. So if the proposal is to be accepted then a tight window should be mandated for the reinvestment into new funds as this ensures that funds remain active in the capital markets, achieving the policy goal of liquidity churn rather than capital exit.”

According to Tanna, a short, fixed period (such as 30 to 90 days from the settlement date) might be proposed to complete the reinvestment into eligible securities.

Tanna also says that similar to Section 54F, if only a portion of the sale proceeds is redeployed into qualifying equity instruments, the LTCG exemption would likely apply on a proportional basis.

However, note that these are proposals which are part of SEBI’s pre-Budget submissions, the final operational rules, time limits, and eligibility criteria will depend entirely on the statutory amendments introduced in the upcoming Budget 2027 in February 2027.

How could the proposed scheme work?

The underlying principle of the SEBI’s proposal is that the law encourages reinvestment of mutual funds holdings by providing conditional relief from capital gains taxation.

Rao says that one possible approach would be to allow investors to switch between eligible mutual fund schemes without triggering immediate capital gains tax, provided the entire redemption proceeds are reinvested within a prescribed period, say 30 days. Alternatively, direct scheme-to-scheme transfers could be facilitated without the money being credited to the investor's bank account.

However, rather than granting an unconditional tax exemption, Rao says that a tax-deferral mechanism would be more balanced. The original acquisition cost and holding period could be carried forward to the new investment, with the accumulated gains becoming taxable when the investor ultimately redeems the investment without making another qualifying reinvestment.

Interestingly, the Income-tax Act already provides tax-neutral treatment for certain mutual fund schemes and plan consolidations although not for individuals. The existing relief, however, is restricted to specified consolidation transactions and does not extend to voluntary switching by investors.

Rao says: “Such a framework could provide flexibility to investors while ensuring that the Government does not permanently lose tax revenue. Of course, suitable safeguards would be required to prevent misuse, particularly through frequent or circular switching of investments.”