Salvage Your Losers With This Easy Strategy

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With temperatures soaring and the kids not yet back in school, the end of the year is probably the last thing on your mind right now. If you're looking to cut your tax bill to Uncle Sam, though, it's not too early to start thinking about turning losses on investments into tax breaks. Moreover, exchange-traded funds make it easier than ever to take those losses without running afoul of arcane tax rules.

The silver lining
No one likes to lose money on a bad investing decision. But investment losses can be used to get extremely valuable tax breaks. When you sell stocks that have fallen in value, you can not only use any capital loss to offset gains on other stocks, but also use as much as $3,000 in additional losses to offset regular income. That deduction can save you as much as $1,050 in federal taxes for those in the top 35% bracket. That can certainly ease the sting of having made a losing investment.

All too often, though, it seems like as soon as you sell a stock loser, it picks exactly that moment to bottom out and start recovering. If you still believe in the stock, and you believe it will recover its losses,  the ideal situation would be simply to buy the stock back right after you sell it.

Unfortunately, so-called "wash sale" tax rules don't allow you to do that. If you buy back the same stock within 30 days of having sold it, then you're not allowed to take a tax deduction for any capital loss from the sale. And if the price of those shares goes back up during the 30-day period, you could simply be out of luck.

Beating the wash sale rules
The solution to this conundrum is simpler than ever, thanks to the growing universe of ETFs. Even though you're not allowed to buy back exactly the same stock, the wash sale rules do let you buy different securities, even if they're quite similar to the ones you sold.

Let's take a couple of examples. First, if you have a loss on an ETF, it's often quite easy to sell that ETF and replace it with another ETF with almost the exact same investment objective. For instance, thanks to the recent correction, anyone who bought SPDR Trust (NYSE: SPY  ) a few months ago is now sitting on a 10% loss. To claim a loss, you can sell those shares and buy iShares S&P 500 (NYSE: IVV  ) . Both track the S&P 500, so any recovery in one ETF is likely to affect the other ETF as well. Yet because they are technically different securities from different issuers, the transactions don't trigger wash sale rules.

You won't always find identical ETFs like this, but much of the time, pairs of ETFs are close enough to work pretty well. For instance, the iShares S&P Smallcap ETF (NYSE: IJR  ) tracks S&P's small-cap index, while the iShares Russell 2000 ETF (NYSE: IWM  ) follows a different index of small-cap stocks. If you sell one to take a loss, and use the other to replace it during the 30-day wash sale period, you probably won't get identical performance. But often, similar ETFs like these are highly correlated, so you won't have too much tracking error.

You can even use this strategy on individual stocks. Shareholders of Microsoft (Nasdaq: MSFT  ) , for instance, have suffered substantial losses so far this year as the company struggles to figure out how best to utilize vast cash reserves productively. Similarly, Cisco Systems (Nasdaq: CSCO  ) took a big hit just this week, as investors started giving up on seeing a strong recovery. If you have losses on those stocks, you could sell them and buy shares of technology sector ETF Select SPDR Technology (NYSE: XLK  ) , which owns healthy portions of both stocks, as well as other tech stalwarts like Google and Oracle.

Be tax-smart
Navigating the wash sale rules to take advantage of tax losses may seem like a complicated strategy with a relatively small payoff. But every dollar you can recover from the IRS is a dollar you can use to invest or cover your spending. In a tough economy, that can make a huge difference.

Not all ETFs are smart investments. Tim Hanson has the lowdown on some dangerous ETFs for international investors.

Fool contributor Dan Caplinger has always thought being a salvage diver for gold bullion on sunken ships would be a cool job. He doesn't own shares of the companies or ETFs mentioned in this article. Google and Microsoft are Motley Fool Inside Value recommendations. Google is a Motley Fool Rule Breakers pick. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Google and Oracle. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy always looks for a silver lining.

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  • Report this Comment On September 08, 2010, at 5:55 PM, mikewang0 wrote:

    Another way to do this is to shift the asset between retirement and non-retirement account. Say, sell in non-retirement account and buy back in an IRA account.

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