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Towards the end of the year, many investors begin scouring their portfolios for investment losses, with an eye toward tax time. As painful as it can be to make a bad bet on a stock, mutual fund, or ETF, tax-savvy investors know that there is no limit to the dollar amount of capital losses that can be used to offset capital gains earned during the year. In addition, up to $3,000 worth of capital losses can be deducted from ordinary income. Clearly, knowing when and how to use capital losses is an important part of an overall tax-planning strategy for any investor with securities in a taxable account.

Tax-loss harvesting, however, is something investors can do year-round, and the proliferation of exchange-traded funds has made it easier than ever.

For investors who aren’t familiar with how tax-loss harvesting works, the process is fairly straightforward. Simply identify the securities—mutual funds, stocks, or ETFs—in your portfolio that have gone down in price since you purchased them. Once you decide which securities to sell and make the appropriate trades, you must wait 30 days before buying the same—or “substantially identical”— securities back. Otherwise, the Internal Revenue Service will disallow your capital loss.

This 30-day waiting period is sometimes referred to by accountants and investment professionals as the “wash-sale” rule. (Note that the IRS will also disallow your capital loss if you purchase the same or substantially identical securities during the 30-day period before the date of your loss sale.) The rationale for this rule is that Congress, when drafting this provision of the tax law, determined that selling a security at a loss and then immediately repurchasing it did not justify a benefit. Such a transaction would simply be a “wash.” For a loss to generate a legitimate tax benefit, our lawmakers reasoned, an investor should actually have to remove that security from his portfolio, for at least 30 days.

Despite the tax benefits of this technique, tax-loss harvesting presents investors with a couple of dilemmas. First of all, many investors are reluctant to tinker with their carefully constructed portfolios, particularly if they are invested for the long term. More to the point, it may not be worth converting an unrealized loss into an actual loss if it means parting with a promising mutual fund or stock for several weeks. Short-term market moves are always difficult to predict, and an investor could easily wind up sitting on the sidelines during a rally.

This is where ETFs come in. While the wash-sale rule prohibits the purchase of “substantially identical” securities during the 30 days before and after the loss sale, it doesn’t prevent the purchase of an ETF as a “placeholder” for the stock or mutual fund, and as we’ll see in many cases, the ETF being sold.

Here’s an example. Let’s say you’ve decided to harvest tax losses from Fidelity Select Medical Delivery Portfolio [FSHCX], a mutual fund of hospitals, nursing homes, health maintenance organizations, and other companies specializing in the delivery of health care services. During the fourth quarter of 2007, the top holdings in this fund included UnitedHealth Group, McKesson, Express Scripts, Cardinal Health, and CVS Caremark. Because the IRS does not consider traditional, actively managed mutual funds and ETFs to be “substantially similar” investments, you could keep your exposure to this sector by purchasing the iShares Dow Jones U.S. Healthcare Providers Index Fund (IHF) and still retain the tax benefits of your capital loss. The recent top holdings of IHF are similar— though not identical—to those of FSHCX and would allow you to take advantage of an upswing in that sector of the marketplace. The bottom line: selling FSHCX and buying IHF is not a wash sale.

Note that ETFs can be used as placeholders for individual stocks just as they can for mutual funds.

What about harvesting tax losses from one ETF and replacing it with another? Under IRS rules, this is permissible as long as the ETFs are based on different indexes. Thus, the tax benefit would be allowed if an investor sold his S&P 500 Index Fund (IVV) at a loss and replaced it with the iShares Morningstar Large Core Index Fund (JKD). However, the IRS would disallow the benefit if IVV were replaced with State Street’s SPDR S&P 500 ETF (SPY), because both funds are built on the same underlying index.

So when does it make sense to harvest tax losses from an investment? While the end of the year is the time most investors review their portfolios for potential tax losses, it’s a strategy that can be used year-round. One caveat, of course, is to watch out for trading costs; you don’t want constant buying and selling to overwhelm the tax advantages of this technique.

The other point is that tax-loss harvesting, while a good way to salvage something from an investment (or two) that has headed south, is of no real value if there are no capital gains taxes to offset. In other words, a well-constructed portfolio that’s generating consistently healthy returns is still the mainstay for any long-term investor. Tax considerations, while important, are secondary.

Source: Benefits/Drawbacks of Tax-Loss Harvesting with ETFs