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Funds as 'Placeholders' in Tax-Loss Sales

Funds and ETFs can fill in, but there are still IRS questions.

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



instead of



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.

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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:




KB Home



DR Horton


. 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


from State Street and Barclays'

Dow Jones US Home Construction Index iShare



It's been a grim year for anyone holding









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

HOLDRS Internet exchange-traded fund


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

Looking to take your loss in



? A mutual fund,


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


also tracks Intel, and its peers, pretty well.

Mobile-technology plays






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


Fidelity's Select Communications Equipment fund.

It's been a year to forget for



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

Dow Jones US Health Care Providers iShare


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




St Jude



iShares' Dow Jones US Medical Devices Index


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

Boston Scientific


, 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


has done the best job of tracking



, while if you're looking totake your loss in



, I'd go for the

HOLDRs Biotech




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.