Making changes to your investment portfolio simply for tax purposes is never a cut-and-dried decision, and I’ve never been one to suggest you should let the tax tail wag the portfolio dog.

That being said, it would be a shame to end a year that will give us portfolio losses—barring some miracle—and also end up paying taxes on funds’ year-end distributions without trying to at least minimize the impact.

Vanguard recently said that it doesn’t expect to make big, or many, capital gains distributions this year, but you never know, and it’s always good to be prepared for the unknown. To that end, here are a few things to think about if you think you want to realize some losses in your portfolios now. (See also: “5 Vanguard Funds to Sell Now.”)

First, of course, don’t go taking losses in a fund that you’ll have trouble buying back into. Remember that, because of Vanguard’s limits on trading and investments into closed funds, selling may not be to your advantage if you can’t put the bulk of your money back into the fund.

For instance, non-Flagship shareholders are limited in their ability to add to funds such as Capital
Opportunity (VHCOX) and PRIMECAP (VPMCX). You wouldn’t want to sell off $50,000 worth
of Capital Opportunity shares and then be limited to adding back just half that amount.

Second, don’t fall prey to the washsale rules. In short, if you sell shares at a loss within a 30-day window on either side of a purchase of shares in that same fund (whether through reinvestment or outright purchase—it doesn’t matter), you will not be allowed to realize that loss for tax purposes. The wash-sale
rule’s intent is to prevent you from selling a fund or stock, say, for a loss on Monday and then repurchasing it on Tuesday.

The wash-sale period is actually a 61-day window which includes the day you sold your fund (or stock
or bond) at a loss plus the 30 calendar days on either side of it. The rule concerning a purchase within 30 days prior to the sale has to do with “replacement shares.” If you have purchased identical “replacement
shares” within the 30-day window prior to the sale, this would disallow taking the loss.

For instance, if you own 100 shares of Fund XYZ at a cost of $50 and you buy another 100 shares
on November 1 at $40, then sell 100 shares on November 3 at $41. You try to take the loss on the $50 shares but you can’t because you bought 100 identical shares just two days before.

That’s a no-no…

Investors who reinvest monthly distributions from their fixed-income funds are particularly susceptible to running afoul of the wash-sale rule since they may buy shares every month.

And if you think you’ll be able to take a loss on some fund shares after a dividend distribution and reinvestment, when the share price has fallen, think again. To do so before the end of the year will certainly put you inside the dreaded 30-day window. (See also: “7 Mutual Fund Mistakes to Avoid.”)

Also, if you’ve already reinvested your income fund’s November income distribution, you won’t be able to book a loss on a sale in December. That said, the loss that is disallowed is only on shares equal to the number purchased inside the 30-day window. So, if you’re selling 2,000 shares to take a loss and you happened to reinvest a distribution and got 5 shares in the transaction, you’ll still be able to deduct the loss on 1,995 shares.

The issue of not buying something again within 30 days of realizing a loss leads directly to my next bit of advice, and something I’ve told investors to do for years. Rather than automatically reinvesting, have Vanguard send your distributions to your money market fund instead.

That’s right: Don’t reinvest, particularly if you’re doing some tax-loss selling within the 30-day window
prior to a fund’s distribution date. This is particularly important if you’re selling only a portion of your
shares in a fund to take a loss, and doing so close to a distribution date.

For instance, you’ve bought shares every month and now want to sell only those that are underwater. The problem is that you will still receive a distribution on your remaining shares, and if you reinvest
your distribution (within 30 days of taking the loss), you’ll run afoul of the aforementioned wash-sale rule.

Fund investors have a way around the wash-sale rule, of course. We can sell a fund to take a loss and buy
a similar investment, which we then hold for 30 days. After that time, we can sell it and repurchase the original, preferred fund if we want. The funds can’t be exactly alike, however, such as exchanging one S&P 500 index fund for another (though exchanging for an ETF might work), or selling a fund’s
Admiral shares and buying the Investor shares.

The IRS frowns on these shenanigans, though I’m not aware of its having been tested in tax court. But
better to be safe than sorry.

One last thought. If you do want to make some allocation changes or do some rebalancing in your portfolio, take your losses in this calendar year, but wait until January 2, 2009, to take gains. That way, you can use your losses on your 2008 tax return, but you won’t owe the IRS taxes on your gains
until you file in 2010.

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