Use ETFs to Dodge Tax-Loss Rules

Time is running out for investors to harvest tax losses in their portfolios. There are only 35 days left in 2007 -- and just 24 of those are trading days.

The danger with dumping depreciated stocks and then using the tax losses to offset gains is that the stock could take off after you sell it, leaving you on the sidelines. Under tax law, investors are prohibited from taking a loss on stocks if they purchase "substantially similar" securities within 30 days.

Exchange-traded funds, which are baskets of securities that trade on an exchange, like stocks, avoid being washed away by the so-called "wash-sale" rule.

Unlike actively managed mutual funds, which report their holdings on a quarterly or twice-annual basis, ETFs update their portfolio holdings and weightings on a daily basis. The information can be found on most ETF Web sites. So investors can shop around for the one that's best suited for a basic tax-planning strategy called a tax swap, which entails selling one security and simultaneously purchasing one that is similar, but not identical.

For example, say you sell drug stock ABC for a loss, and buy a drug-stock-based ETF called XYZ to replace it. You can use the loss from selling ABC on your tax return to offset gains realized elsewhere in this portfolio. This could help reduce taxes due for the current year while allowing you to maintain your exposure to the drug sector.