With all joy comes a little sorrow. So it is during the holiday season, when all good investors should start planning what they'll give to the toughest name on the list, the Internal Revenue Service.

Like Santa, the IRS keeps track of your behavior. The more you receive, the more it expects to get. One way to reduce taxes on profits taken on winners is to realize losses by selling holdings that are down.

But with the stock market just recently regaining its fervor and roaring to a new 52-week high, many investors are understandably reluctant to sell holdings simply for tax purposes. If you think the stock is a dog and has little chance of recovery, then by all means dump it. If, however, you still believe in a company's long-term prospects, there is a strategy that allows you to both retain ownership and realize a tax loss in 2004.

Before we go any further, remember that you should always consult a qualified tax expert before making any transactions. Tax laws, especially those related to investing, are notoriously complex and constantly changing. Each situation is handled differently. I'm not a tax expert, but one thing I can say without equivocation is this: Don't try to use options to avoid taxes. If you owe taxes, you will pay -- one way or another.

Time to Do the Wash

Congress created the "wash sale" rule to prevent taxpayers from selling stocks at a loss and then reacquiring "substantially identical" securities within a 30-day period before or after that loss (and thereby claiming a tax loss). A 1988 amendment defined options and various combination positions as "substantially identical" to the underlying stock; thus, they are subject to wash-sale regulations.

That means a wash sale exists when you close an option position at a loss, or if you establish a replacement position within the 61 days surrounding the realized loss. This also means you can't just sell out a stock and then buy it back the next day. Nor can you purchase calls or sell deep-in-the-money puts.

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