Funds as 'Placeholders' in Tax-Loss Sales

Funds and ETFs can fill in, but there are still IRS questions.
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That stock you own. The one that's been stubbornly ignoring the bull market, and your repeated pleadings, and sinking like a stone all year. You know the exact moment when it's going to turn around. It will be the day after you sell it to book the tax loss.

It's Murphy's Law, Wall Street-style.

That will be the moment when the company finally says business has turned the corner. Or that the dismal chief executive has at long last been ousted. Or that Bain Capital has arrived with a fat, juicy takeover bid.

And after all that selling pressure, it probably won't move just 10 cents. You'll see dollars slapped on the price within moments. And you won't be on board. It's a problem.

Those tax losses should come in useful this year. If you're a typical investor in stocks, bonds or funds, you'll be looking at some capital gains thanks to this year's rising market. But under IRS rules, you can't just sell a failing share, book the loss against your capital gains for the year, and then buy the stock back. You have to wait 30 days, sitting on the sidelines, before repurchasing the stock.

That can be an agonizing wait. Just what you don't need for the holidays. The IRS says that you cannot sell an investment and park the money in a "substantially identical" one for 30 days. That includes a contract to buy that investment -- so you can't sell the share and buy a call option on it.

Irritated investors have come up with a variety of workarounds over the years. The most obvious is to sell the stock and buy its nearest competitor, such as holding

Merck

(MRK) - Get Report

instead of

Pfizer

(PFE) - Get Report

for 30 days. The downside is that you're open to a lot of market "noise" on individual stocks.

The good news? If you're holding one of Wall Street's worst stocks this year, there's a pretty good chance there's a mutual fund or an exchange-traded fund that can work as a makeshift placeholder instead.You can sell the stock, park that money in a fund that tracks the same industry sector for 30 days, and then, if you want, sell the fund and buy back the stock.

It doesn't cover you completely. And there are still some questions about IRS rules (more about this below). But using a fund can be a decent workaround.

That's especially true if your stock is part of a sector that's out of favor across the board. Broadly speaking, you'd expect the shares to rise, and fall, in tandem.

Look at homebuilding stocks. The stock market has taken a wrecking ball to the entire sector this year, as house prices have finally begun to fall. Among those left in the wreckage:

Lennar

(LEN) - Get Report

,

KB Home

(KBH) - Get Report

and

DR Horton

(DHI) - Get Report

. If you're sitting on a loss on any of these and want to book it for tax purposes, there are two exchange-traded funds that track the sector:

The Homebuilders SPDR

(XHB) - Get Report

from State Street and Barclays'

Dow Jones US Home Construction Index iShare

(ITB) - Get Report

.

It's been a grim year for anyone holding

Amazon

(AMZN) - Get Report

,

eBay

(EBAY) - Get Report

or

Yahoo!

(YHOO)

shares. They survived the dot-com bust together. Now they're sinking together. Nearest ETF equivalent: the

HOLDRS Internet exchange-traded fund

(HHH)

. At last count, it was 29% invested in eBay, 26% in Yahoo! and 13% in Amazon.

Looking to take your loss in

Intel

(INTC) - Get Report

? A mutual fund,

(SMPIX) - Get Report

ProFunds Semiconductor Ultra Sector, has 20% of its money in the stock and the rest across correlated companies in the industry. The

HOLDRS Semiconductor ETF

(SMH) - Get Report

also tracks Intel, and its peers, pretty well.

Mobile-technology plays

Qualcomm

(QCOM) - Get Report

or

Motorola

(MOT)

are both down for the year. One mutual fund has done a pretty good job of tracking both:

(FSDCX) - Get Report

Fidelity's Select Communications Equipment fund.

It's been a year to forget for

UnitedHealth

(UNH) - Get Report

, the stock-option-backdating company that also runs hospitals. Barclays'

Dow Jones US Health Care Providers iShare

(IHF) - Get Report

is 14% exposed to the stock -- and since its launch this spring, has correlated extremely closely to its performance.

For investors in medical devices companies

Medtronic

(MDT) - Get Report

and

St Jude

(STJ)

,

iShares' Dow Jones US Medical Devices Index

(IHI) - Get Report

offers the closest proxy. Note: It also has 8% of its money in

Boston Scientific

(BSX) - Get Report

, but that company's specific troubles mean you're on your own.

And this has been a bad year for investors in some of the leading biotech companies. The

Nasdaq Biotechnology Index iShare

(IBB) - Get Report

has done the best job of tracking

Amgen

(AMGN) - Get Report

, while if you're looking totake your loss in

Genzyme

(GENZ)

, I'd go for the

HOLDRs Biotech

fund

(BBH) - Get Report

instead.

There are two important caveats to this. First, none of these workarounds are perfect or anywhere near. If they were, the IRS wouldn't allow you to claim the tax loss. However, they should dosomething to minimize the danger of getting embarrassed by a sudden sector rally the instant you take your tax loss.

Second: The IRS rules, as usual, aren't completely clear. But when it comes to using sector funds, finance professors and tax experts A. Seddik Meziani and James G. S. Yang suggest the advantage is on yourside. They wrote a paper on precisely this subject in the monthly

Practical Tax Strategies

last year. And they suggest sector funds should avoid the IRS bar on "substantially identical" investments."Sector ETFs are currently not recognized by the IRS as identical to the stocks that comprise their holdings," they wrote.

They note the IRS has already cleared people to park tax losses in other vehicles that would seem to be a lot closer to the original investment than a sector fund -- like bonds from the same issuer but ofa different duration, or preferred and common stock from the same company.

The one risk they raise: There is a chance you could lose the tax benefit for that percentage of the sector fund which is specifically invested in the stock you just sold. So if you sell eBay and put the money in the Internet HOLDRS fund, which has 29% of its money in eBay stock, there is a possibility the IRS might argue that you "kept" 29% of your stock.

But even this isn't clear, Meziani and Yang argue. They also note that even if the IRS does eventually take that position, it might not be applied retroactively. As always in these matters, you should consult your tax adviser. As the IRS will tell you, only two things in life are certain.