Once a year, every year, the tax man starts to get interested in how your investments have worked out, as once a year, every year, the tax man gets to take a bite based on those returns.

Well, not exactly -- if you're holding a company like Denny's that has shot the lights out this year, and you still hold it, then the IRS is not so interested in you. But a Sirius Satellite Radio (NASDAQ:SIRI), or a Travelzoo (NASDAQ:TZOO), which have gone up a great deal and have average holding periods that occasionally measure in hours, means there are hundreds of thousands of profitable trades for which at the end of the year people are going to owe taxes at the short-term rate, which equals your ordinary income marginal rate. Although there are worse situations in the world than having to pay tax on profitable trades, each person in this position must ask him or herself the question: Is there something I can do to reduce the amount of money I pay to Uncle Sam?

In fact, there is, and it's called tax-loss selling. We've written about this strategy on numerous occasions in the past, and I'll link to a couple of articles from the Fool's own tax expert, Roy Lewis, at the bottom of this article. Since we're in December, it's time to bring the good and the bad of the tax-loss strategy back to the fore. Please note that I and every other Fool author who has written about this topic is doing so generally -- we do not and cannot know the details of your individual situation, particularly when it comes to what taxes you will owe. Pay special attention to Roy's description of the "wash sale" rule, and if you're unsure of your position, get some advice.

Calling all losers
Even for the folks who tend to measure stockholding periods in years or decades, there comes a time when we will say "sayonara" to most positions. I did so earlier this year to Reynolds American (NYSE:RAI) when its share price soared over $75, about where it sits at the moment. Let's use this one as an example. Seeing as I had bought the position at about $30, this generated a pretty substantial gain for me, upon which I'll have to pay tax. Unless, of course, I have a stock that I have either sold or will sell that nets out the gains from Reynolds. So if I have a $10,000 gain in Reynolds, if I have $10,000 in total realized losses, the out-of-pocket tax impact to me would be zero. So that would mean that I look down the list of companies I hold and look for ones where I have a net loss at the moment. If I held shares (I do not) in Wilsons Leather (NASDAQ:WLSN) for almost any length of time more than one year, I'd have an unrealized loss. To harvest it against my Reynolds gain, all I'd need to do would be to sell Wilson's and realize the loss.

There are complications here, and they're important. First, of course, is the wash sale rule, which states that your loss sales must "stay sold" for a period exceeding 30 days. If you buy back in part, or buy back in a different account, or play other games where you still hold economic interest in the company, you'll void the tax benefit. Thirty-one days later, though, you're welcome to buy the stock back and make the claim on your tax form. Some people claim that the IRS will do nothing if you sell a stock in a taxable account and rebuy it in a tax-deferred one. I wouldn't recommend testing the tax man on this. You also need to understand that a company that you have sold for tax loss reasons will have its clock reset. So if you hold a company that has dropped in value, and you harvest the losses for tax purposes, when you buy it back, you've got a year before it is considered a long-term holding -- which also has tax implications.

Length of holding also matters in terms of the tax loss. As one might think, long-term losses would match up with long-term gains, and short-term losses with short-term gains. Tax laws require that short-term losses match short-term gains, and long-term losses are netted against long-term gains. Only after every cent of short-term losses are matched with short-term gains can you take any of the short-term losses against long-term gains before the special tax rates are applied. So it's pretty simple.

... don't forget your old losers
Of course, many investors have plenty of losses from past years that we couldn't use in the year they were realized, so they carry forward to be used in later years. So if you, like me, were boneheaded enough to think that Iridium would ever, ever be commercially viable back in 1999, you may have taken several thousand dollars worth of tax losses when the heavy weight of reality ripped off your sepia-colored glasses. If your total losses exceeded your gains in 1999, then the remaining amount can be applied in later years at a clip of $3,000 per year, for as long as you live, or until they expire.

What you have with these old losses are a particularly gruesome kind of asset -- the tax loss carryforward. For folks who lost in the hundreds of thousands of dollars during the dot-com bust, they'll never be able to harvest all of them -- $100,000 in loss in a year equals 33 years' worth of carryforwards. Be that as it may, it would be extremely silly not to count this asset against your taxable gains if you have it.

What not to do
We've talked about the mechanics and described why you wouldn't want to try to monkey around with wash sales. What else is there to consider? A few things come to mind, but they all fall around the same rubric: Do not allow tax considerations to take precedence over good investing decisions. Transaction frictions such as tax are a reality in buying and selling securities. But getting too cute with them can cost you.

The tendency is to try to delay taxes -- certainly this is a positive goal, right? Yes, but if it's December and you're holding a company that you now believe is grossly overvalued and are getting sick with anxiety at night hoping it holds on at this price until the beginning of the year so you can push the tax into 2005, do yourself the favor and sell it. Just like people have occasionally cost themselves enormous gains by saying "well, Microsoft's (NASDAQ:MSFT) too expensive at $25, but I'll buy it at $24," and never seeing that price again, it is not unprecedented for stocks to drop, precipitously, on their own schedule, not yours. If you can stomach that risk, do so. If you cannot, don't. To harvest a gain, you must first have a gain.

Secondly, don't sell winners just to net against losers you've already sold. If you believe that a company is undervalued, even if you've gained on it from where you bought it, you run the risk of missing out on a run-up to its full value. Let your investing common sense drive your tax abatement decisions, not the other way around. If you're happy that a company is fully valued, selling to match against realized losses becomes a bonus. And thirdly, recognize that the company that you're selling to harvest losses might be undervalued. (Why hold on to it long term if you think it's anything but?) If you sell a company for tax-loss reasons and it starts to run before your 30 days runs out, try not to panic. It's a pretty dim case to buy back in for the fear of "missing out" and not only miss out on a run-up, but hose your tax benefit, the reason you sold, in the first place. If you sell something that you would otherwise hold for tax purposes, just recognize that you're running such a risk.

Most of all, take some time before you pull the trigger to reassess a loser. It could be -- and certainly, at some point, it will be -- that you made a mistake when you bought a company, and the trade has gone against you. If you have existing capital gains, and you have a company that has declined and you no longer like its prospects, why in the world would you not sell it in December?

For more, better information, see The Motley Fool's Investor Tax Issues Center and:

Bill Mann's loss carryforwards for Iridium ran out in 2001. The distrust his wife holds in his judgment for buying the stock in the first place carries on to this day. He holds shares in Denny's. For more on retirement and investment issues, take a free trial in Robert Brokamp's dynamite newsletter, Motley Fool Rule Your Retirement.