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Tax Tips: Use Portfolio Losses to Soften the Blow

You can use investment losses to offset up to $3,000 of ordinary income.

As Dec. 31 draws ever nearer, you'd be well served to think about moves you can make now to lower your 2007 tax bill.

In previous installments, we've covered adjusting your

withholding, maximizing contributions to

retirement savings, planning for the

alternative minimum tax and taking advantage of

tax credits related to energy efficiency. In this final installment, we'll discuss harvesting losses in your investment portfolio.

Before you begin tax-related tinkering with your portfolio, consider your ideal asset allocation. Once you've settled on a mix of stocks, bonds and cash that makes sense in light of your long-term goals, determine how your actual portfolio stacks up. Only then should you begin looking at the individual winners and losers you own.

If you've reaped capital gains this year, think about offsetting them by harvesting some losses. For a given tax year, if you end up with a net loss, you can generally use it to offset up to $3,000 of ordinary income ($1,500 if you're married filing separately). And unused losses can generally be carried forward to use against gains realized in future years.

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For example, if you have a capital gain of $2,000 as well as $6,000 of capital losses, you can use $3,000 of your losses to offset ordinary income dollar-for-dollar this year. You can carry the remaining $1,000 in losses forward to your 2008 tax return.

"The end of the year is a great time to see if there's anything in your portfolio that you want to ditch," says Maggie Doedtman, an enrolled agent with H&R Block in Kansas City. "Just remember: Tax considerations should be part of that strategy, but they shouldn't be the whole strategy."

So you might want to hold on to a stock that fits your overall strategy but that experienced what you feel is a short-term loss. On the other hand, if you've got a losing stock that you think is going to continue its downward spiral, consider selling it to take advantage of the losses.

If you do so, be sure to stay on the right side of

IRS rules regarding wash sales. Essentially, if you sell shares of a security at a loss, you can't buy the same security within 30 days of the sale and still realize the loss.

One additional technique you might consider is donating appreciated stock to charity. "This lets you avoid the capital gain and get a deduction for the security's fair market value, assuming you've held it for at least a year," says Tom Scanlon, CPA, CFP with Borgida & Co. in Manchester, Conn.

One caveat: You may only deduct property valued at up to 30% of your taxable income in any one year, although you may carry the deduction forward. So if your taxable income is $100,000 and you donate a stock valued at $40,000, you can deduct $30,000 this year and carry the additional $10,000 forward to your 2008 tax return.

Michaela Cavallaro writes about personal finance, business and food from her home in South Portland, Maine.