Play Clean With Wash Sale Rule

You can still book some losses for this year, but be careful not to get them disallowed by the wash sale rule.

Run, don't walk, into the high yields and safety of municipal bonds. Which ones? Click here for current buys from Marilyn Cohen in Forbes Tax-Advantaged Investor.

Several times in the first half of 2008, it looked like the Federal Reserve and the Treasury just might be able to pull the U.S. economy and financial markets out of the enveloping funk that began to gather in earnest about one year ago as stocks topped out. As we now know, the pain was just beginning and stocks went on a big slide; the Dow Jones Industrial Average now has a virtual lock on finishing 2008 with one of its five worst annual percentage losses in the history of the index, nestled among Depression-era years and the horrendous Panic of 1907.

Add to the steep slide in the overall market a far more precipitous crash in all things related to commodities and emerging markets and you could be forgiven for getting caught still holding a few losers in your portfolio this time of year--maybe a copper stock, a few Chinese stocks, an oil company or fertilizer maker, or perhaps mutual funds or exchange-traded funds that hold some of these hot investments gone cold. You may have had a massive capital gains distribution this month, or are about to have one, and you'd like to reduce your tax liability.

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Now it's time to counter that pain you've felt as an investor with at least a bit of relief as a taxpayer.

Selling out of losing investments inside of a taxable account allows you to realize both short-term and long-term capital losses, which you can use to offset gains for tax purposes. If your losses exceed your realized gains, you can deduct up to $3,000 from ordinary income for the tax year when you booked the loss--and carry forward anything above $3,000 until you die.

But if you want to make sure your losses do some good for you this year, you need to pay attention to something called the "wash sale rule," which disallows a realized loss if you purchase the same, or "substantially identical securities," 30 days before or 30 days after the day you booked the loss.

It is not the end of the world to have a wash sale disallowed: The IRS simply adds back the amount of the disallowed loss to your original basis, in effect lowering your tax burden in whatever year you properly dispose of the investment.

If you were counting on that loss to offset gains you made this year, however, you need to make sure to play by the rules. Section 1091 of the Internal Revenue Code details the wash rule and the IRS lays it all out in Publication 550, available on its Web site.