Use ETFs to Dodge Tax-Loss Rules

You can get around rules forbidding taking a loss on stocks rebought within 30 days.
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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.

Under the wash-sale rule, the investor cannot claim ABC as a tax loss unless he or she waits 30 days before buying it back. But you need not kick yourself if ABC happens to rally during the 30-day wash-sale period, because you can enjoy part of the gain via your holding in the XYZ ETF.

"People that are intellectually preparing for the year-end tend to do the bulk of their tax-selling in November, so they have the opportunity to repurchase before the end of the year and avoid the wash-sale rule," says Phil Roth, technical analyst at Miller Tabak.

Here are two strategies using ETFs for investors who are resolute and smart enough to do their tax planning year-round -- although you should always check with your tax adviser before making any moves:

Strategy 1: Taking Individual Stock Losses While Maintaining Sector Exposure

In this case, let's use a real but somewhat arbitrary example. Let's say you are holding too large a position in

Wal-Mart

(WMT) - Get Report

and your portfolio is dangerously out of balance. Furthermore, the Wal-Mart shares you purchased happen to be trading below your purchase prices.

Because Wal-Mart accounts for more than 8.5% of the

Consumer Staples Select SPDR

(XLP) - Get Report

, an ETF that contains the 37 consumer staples listed in the

S&P 500

, you can: (1) sell your Wal-Mart stock; (2) claim the loss on your tax return; and (3) buy the Wal-Mart-heavy ETF to maintain your exposure to Wal-Mart and to that sector in general.

Ater 30 days, you can choose to buy back some or all of your Wal-Mart position and sell the ETF.

Dan Dolan, an ETF specialist, says investors also can use this strategy to take a loss in a open-end mutual fund or closed-end fund while maintaining exposure to a particular sector. For example, if you are holding a technology fund that is currently underwater, you can sell the fund, realize the loss and buy a tech ETF like the

Technology Select SPDR

(XLK) - Get Report

to stay exposed to the sector.

Strategy 2: Swapping One ETF for Another

Paul Mazzilli, an ETF strategist at Morgan Stanley, says investors also can swap sector ETFs "if they have similar -- but not exactly the same --- holdings, and are based on different indexes."

Again, let's use actual securities for a hypothetical example. This means that investors staring at unrealized losses in the

iShares Dow Jones US Healthcare ETF

(IYH) - Get Report

can switch into the

Vanguard Healthcare Viper

(VHT) - Get Report

or the

Healthcare Select SPDR

(XLV) - Get Report

for 30 days and still comply with the wash-sale rule.

Mazzilli says the swap is kosher under the wash-sale rule because each ETF corresponds to a different index. The Dow Jones Healthcare ETF tracks the performance of the Dow Jones U.S. Healthcare Sector Index; the Vanguard ETF follows the MSCI U.S. Investable Market Health Care Index; and the Select Spider tracks the health care components of the S&P 500.

Before joining TheStreet.com, Gregg Greenberg was a writer and segment producer for CNBC's Closing Bell. He previously worked at FleetBoston and Lehman Brothers in their Private Client Services divisions, covering high net-worth individuals and midsize hedge funds. Greenberg attended New York University's School of Business and Economic Reporting. He also has an M.B.A. from Cornell University's Johnson School of Business, and a B.A. in history from Amherst College.