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Offset taxable ’06 gains by swapping munis in the nick of time

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in Small Business Tax

As the days remaining in 2006 dwindle down to a precious few, you may be desperately seeking capital losses to offset capital gains realized earlier in the year.

But you may not have any viable stock losers in your portfolio, or you might not have any other assets you want to give up right now.

Fortunately, you can still save the day if you own municipal bonds that have been under-performing. But you’ll have to act quickly.

Strategy: Swap the bonds you own for other munis in the secondary market. Then, you can use the loss from the swap to offset your capital-gain income (plus, up to $3,000 of ordinary income).

In fact, if you play your cards right, you could walk away with a higher-yielding bond.

Although you can swap corporate bonds in that manner, the marketplace for municipals is known to be more active than the corporate bond marketplace.

Here’s the deal

Swapping bonds is actually a simultaneous sale and acquisition. You sell a bond that’s showing a paper loss and, at the same time, buy a different bond with similar investment characteristics (e.g., the same face value).

When the swap is complete, you’re essentially in the same investment position as you were before the swap, except that, now, you have a current tax loss.

Icing on the cake

The bond you acquire in the swap could carry a higher interest rate than the bond you traded away (see box at left).

You’ll probably need the help of an investment pro to navigate the bond marketplace. Traditionally, year-end is the optimal time for muni-bond swapping. But the longer you wait, the more difficult it will be to find replacement munis.

So, start scouting out the options today.

One potential tax trap: If you exchange substantially identical bonds, you may not be able to deduct your loss because of the wash/sale rule. That prohibits you from realizing a tax loss if you reacquire a substantially identical obligation within 30 days of the sale.

Tip: Exchange bonds of different issuers. If you’re swapping bonds from the same issuer, make sure they differ by at least five years in maturity dates and in yield to maturity by 1 percent to 2 percent.

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