Let us assume that an investor Amit Shah has purchased mutual funds worth Rs.200,000/- (10,000 units at NAV of Rs.20/- each). 10 days after the purchase was the dividend record date where the fund declared a dividend of Rs.2 per unit. Thus Amit received a tax-free dividend of Rs.20,000/- from his mutual fund holdings. Typically, the mutual fund NAV adjusts downward to the extent of the dividend declared after the record date. Thus the NAV of the fund goes down to Rs.18/- after the record date. If Amit sells his units after the record date, then he books a loss of Rs.20,000/- {10,000 units X (20-18)}.

Let us also assume that Amit has a short term capital gain from sale of shares to the extent of Rs.30,000/-. Now he can write off his loss on mutual funds of Rs.20,000/- and reduce his short term capital gains from equities to just Rs.10,000/-. He effectively saves 30% of Rs.20,000 (Rs.6,000) as tax. Why is this called dividend stripping? The loss on mutual funds is notional because the Rs.20,000 has already been stripped out of the fund in the form of tax-free dividends. This is a double benefit for the investor as he received tax-free dividend as well as reduces his overall tax liability. This used to happen more in short term capital gains because long term capital gains were tax free up to 2018 and hence long term losses were not admissible for a set off.