Ugh, it was hard to take the loss on XYZ.

You nurtured it, coddled it, tried to think positive, begged for it to turn around and come in for you. But it didn't happen.

So at the end of the tax year, you sold it, to harvest the loss against some other winner in your portfolio.

But seller's remorse has hit. You wake up, 4 a.m., for days on end. You still believe XYZ might be a well-disguised winner. Those thoughts are reinforced by the usual year-end "January effect" commentary: This year's losers, sold off and further depressed, are destined to become January's bargains.

Like a longtime significant other, you can't let go completely. You feel the urge to buy back ASAP.

But the so-called wash sale rule jeopardizes the tax loss for which you sold the stock, raining on that parade.

There might be a way out. But first, a refresher on wash sales.

The idea of the wash sale rule is to keep investors from harvesting tax losses, thereby depleting the U.S. Treasury, only to come away unchanged thereafter. Even though you're more likely to pay taxes on later gains, as your basis on repurchased securities is lower, the Congress and the IRS don't like that timing proposition. Oh, well.

Straight from IRS Publication 550 -- Sales or Trades of Investment Property, here's the IRS take.

A wash sale occurs when you sell or trade stock or securities at a loss, and within 30 days before or after the sale you:

  • Buy substantially identical stock or securities
  • Acquire substantially identical stock or securities in a fully taxable trade, or
  • Acquire a contract or option to buy substantially identical stock or securities

If you sell stock and your spouse or if a corporation you control buys substantially identical stock, you also have a wash sale.

So you can't repurchase the shares you sold within 30 days. And you can't buy something "substantially identical," you can't have your spouse buy it back (or your company), and you can't buy a "contract or option" to buy such substantially identical securities.

What can you do?

Some may skate close to the law by buying an option expiring further out than 30 days.

So-called LEAPs, or long-term equity anticipation securities, which may expire several months to a couple of years down the road, come to mind. (We're talking specifically about buying call options; that is, the option to buy shares at a specified price on or before a specified expiration date.) I've seen articles suggesting that buying LEAPs is OK, perhaps because the expiration date lags the 30-day window.

I'm not so sure I'd take this chance, so here's my play.

Click here for the video version of this story from Jennifer Openshaw.

If you sold XYZ but have a nagging feeling it has bottomed and is due for a rebound, then sell a put option.

You can date this to expire near the 30-day window or further out.

A put option is the right to sell a stock at a given price at or before the expiration date. So if you sell a put, you're saying you'll buy someone else's shares at that price. Meanwhile, you have the cash from your original sale to do so. Thus, the option is fully capitalized by the sale of the stock, but has the similar risk of owning the stock.

If the price goes up past the strike price, you'll keep the entire premium, or price of the put. Sure, if the stock doubles before the end of January, you won't get all of that benefit, but what are the chances of that? And at least you'll get something.

(Keep in mind that selling an in-the-money put might be construed as wash depending on the strike and expiry, so always check with a tax professional regarding your specific situation.)

Take, for example, shares of Cincinnati-based laser vision correction provider LCA Vision ( LCAV).

Trading as high as $57 earlier in 2006, slowing sales growth (down to 30%!) dropped the price to $33, just 15 times earnings. A lot of tax-loss selling, probably.

But LCAV, having just raised its dividend and increased its stock buyback program, seems a good candidate for a January rebound, which would drive down the price of the put you sold or make it expire worthless -- your desired outcome.

So you sell a January put, expiring Jan. 19, 2007, for $2.50. If the stock jumps to, say, $37 after the new year, you keep the $2.50. If the stock drops to $30 for some reason, you'll pay $35 for the stock (the strike price). But hey, if you had kept the stock in the first place, you'd still have a 5-point loss, except you wouldn't have collected the option premium. Nor would you have harvested the tax loss. Either way, it's not a bad deal.

The only way you lose is if it rockets to $40, but you're still better off than if you had sold and then done nothing at all. You collected a $2.50 premium.

Now I always like to explore the risks and rewards of any market play.

  • Greater percentage loss. Sell a put for $2.50 when the stock is at $33, like LCAV. The stock loses $3, or 9%. You would lose $2.50, or 100%, at expiration.
  • Lost opportunity for gains. Stock might recover faster; you leave gains on the table.
  • Cash tie-up. The cash produced from the original sale must be kept aside in case the put is exercised.

But now for the upside:
  • Profit if you were right, by some or all of the option premium.
  • Some downside protection. If the stock drops from $33 to $30 after you sell the put, you take this loss but at least collect the option premium -- better than if you had never sold the stock in the first place.
  • You got the tax loss.
  • You can do it again. If nothing happens, sell another put -- or just buy the stock after 30 days.

The worst thing that can happen: Right or wrong, you end up owning the stock you wanted to own anyway. I don't mind that kind of outcome.

Jennifer Openshaw, a passionate advocate for helping Americans improve their finances and build their personal fortunes, is CEO of The Millionaire Zone and America Online's personal finance editor. In addition to appearing regularly on TV shows such as "Oprah" and "Good Morning America" and on CNN, Openshaw is host of ABC Radio's "Winning Advice" and serves as an adviser to some of America's top corporations. Her new book, "The Millionaire Zone," will hit bookstores in April 2007.

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