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With traditional mutual funds expected to report billions of dollars in capital gains at year's end, investors face a double whammy.

Besides being forced to pay more in taxes, stock funds are producing double-digit losses in 2008. The broad Vanguard Total Stock Market ETF (NYSE: VTI) is down more than 38% so far.

As a result, these are times when the advantages of exchange-traded funds and index mutual funds tend to move to the forefront. The unique creation and redemption process of ETFs, in particular, usually make them a more tax-efficient investment in terms of limiting or even eliminating the burden of capital gains distributions.

But perhaps one of the most neglected tools of ETFs and index mutual funds is their flexibility in tax-loss harvesting. Most don't churn their portfolios much, making them ideal for taxable accounts. That can have drawbacks, though.

Take for example if you'd invested in a fund that tracked the blue chip S&P 500 Index. The granddaddy of the group is the Vanguard 500 Index Fund (VFINX). It has been around for more than 32 years. If you'd been fortunate enough to have bought the index mutual fund when it launched on Aug. 31, 1976, you'd be sitting on a nearly 2,075% cumulative gain.

If you started with $10,000 in the fund, that means an investor making no other contributions would be sitting on about $207,500 in gains. And that includes the 38%+ drubbing that VFINX has taken so far this year.

Making Lemons...

But you can turn such short-term losses into a positive, through exercising Internal Revenue Service provisions allowing a certain amount of tax-loss harvesting.

"In a year like this, almost nobody should be paying any taxes. At a minimum, you should be making sure to eliminate any capital gains liabilities for 2008. That means looking at accounts and making sure you're not in any net positive gains positions," said J.D. Steinhilber, a Nashville, Tenn.-based advisor.

The best-performing ETF in the past three years has been the iShares FTSE/Xinhua China 25 Index (NYSE: FXI). It was averaging annualized total returns of 14.22% through Tuesday. That means you'd have made a cumulative 49% gain over that period and $4,900 in profits on a one-time $10,000 investment.

Now, consider that FXI is down more than 48% this year. You could sell your entire position, or part of it, book those losses in 2008, then repurchase the ETF in 31 days.

So how much can you deduct from your taxes? The first step is to compare short-term gains against short-term losses. Then you need to compare long-term gains to long-term losses. If adding those net totals together results in a negative number, you can use up to $3,000 of those losses to offset ordinary income. And in many cases, you can carry over extra losses to subsequent years.

But that's a rather general summary. Before making any moves, at the very least you should check the step-by-step explanation of the process given on IRS Form 1040's Schedule D. (It can be found on the Internet here).

"One of the most important aspects of tax-loss harvesting is its role in reducing the tax costs of rebalancing, which is critical for managing portfolio risk," said Richard Shaw, an advisor at QVM Group in South Glastonbury, Conn.

But to keep your intended exposure to the market, it's important to make as accurate of a substitute for the fund being replaced as possible.

Let's say you've got the SPDR S&P 500 ETF (AMEX: SPY). You sell it and buy the iShares S&P 500 Index (NYSE: IVV). They're essentially identical, which means you probably wouldn't get any tax benefits for substituting into that fund.

The rather vague IRS rule is that a substitute fund can't be "substantially identical" to the original holding. That's explained on page 55 of the wash-sales provisions in IRS Publication 550. You can find it here.

The official wording doesn't specifically talk about indexes. But the accepted rule of thumb, say advisors, is that the underlying benchmarks must be different to receive favorable tax treatment.

That means you should be able to swap SPY for the iShares Morningstar Large Cap Core Index (NYSE: JKD). That's what Chance Carson does for his clients at Alpine Strategies.

"It's correlated to the S&P 500, but it's a distinctly different index," said the Colorado Springs, Colo.-based advisor. "The one possible negative about JKD is it has much lower volume than SPY and a market cap of only $100 million. So it's not the type of investment someone with a larger portfolio would want to make."

Such liquidity concerns should only apply to investors with portfolios of $10 million or more, he added. As such, Carson says another more liquid choice to temporarily replace SPY might be the iShares Russell 1000 Index (NYSE Arca: IWB).

Another possibility is to stick your money into cash for 31 days. But that's not something Carson advises. "With the market as volatile as it is, that would represent the risk of missing out on a rally in a given asset class," said Carson. "You might wind up making a good market-timing call, but then you've really drifted away from being an asset allocator or a long-term risk manager of a diversified portfolio."

If possible, he advises investors to look for ETFs with average daily volumes of at least 100,000 shares per day. Carson also suggests that individuals delay making tax-loss harvesting moves until mid-December. That's due to the fact that a large number of institutions and hedge funds are wrapping up their tax-related swaps between mid-November and mid-December.

"We don't like to get caught in the extreme volatility of institutional funds and hedge funds selling. Generally, we've found that those sort of swaps die down by around Dec. 15 of each year," said Carson.

He emphasizes that investors need to check with their own tax experts before making any specific tax-loss harvesting changes. But Carson does offer the following list as possibilities for tax-loss harvesting within similar categories and ETFs he considers to show decent liquidity levels:

Category

Original

Possible Replacements

Large Blend

SPY

JKD, IWB, VV

Large Value

VTV

ELV, PWV

Large Growth

IWF

VUG, IVW

Category

Original

Possible Replacements

Small Blend

IWM

IJR, VB

Small Value

VBR

IWN, IJS

Small Growth

VBK

IJT, IWO

Category

Original

Possible Replacements

Foreign Large Cap

EFA

VEU, IOO

Foreign Small Cap

GWX

SCZ, DLS

Foreign Emerging

EEM

VWO, ADRE

Source: Tax-Loss Harvesting: Trickier in More Volatile Times