NEW YORK (CNN/Money) - Is it possible and permissible to offset a long-term loss in stocks with a long-term gain in a mutual fund?

-- Hank Bomberger, Mount Joy, PA

Not only is it possible and permissible, it's usually desirable, assuming you want to lower the amount of money you shell out to Uncle Sam and his minions at the IRS. Not only that, but you've got a lot more leeway in deducting losses than the situation described in your question. Here's the scoop.

Let's say you've got a $10,000 realized long-term gain in a mutual fund. By "realized" I mean you actually sold shares of a mutual fund or the fund manager sold securities and passed that gain along to you and other shareholders via a gain distribution. And by "long term" I mean that you owned the shares for more than 12 months before selling them, or the manager held the securities for more than 12 months (in which case the fund will tell you the distribution represents a long-term capital gain).

(If you have a "paper profit" in the fund -- that is, the value of your shares are more than you paid for them, but you haven't sold -- then none of what I'm saying here applies.)

Assuming you're holding this fund in a taxable account -- as opposed to a 401(k) or an IRA -- you now have a long-term capital gain that can be taxed at capital gains rates as high as 20 percent. So you might have to give up as much as $2,000 of your gain to the IRS.

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Now, let's assume that you also have a stock you've owned for more than 12 months whose price has declined by, oh, let's say $10,000. By selling that stock, you would incur a realized loss of $10,000. You could then use that loss to effectively wipe out the gain in your mutual fund, so that instead of two grand in taxes, you would owe zip, zero, nada.

If your loss was larger than your gain, you could use the remaining loss to offset up to $3,000 of ordinary income, such as that from wages, interest, dividends, and pensions. I like to think of deducting losses as a nice little way to have the government share some of the pain of our investment losses.

By the way, although in this case we used a loss in a stock to offset a gain in a fund, you can also do the same thing with two stocks or two funds.

And while I ignored commissions in the example above for simplicity's sake, you shouldn't ignore them when preparing your taxes. You want to add any brokerage commissions to the purchase price of your stocks and funds and deduct commissions from the sales price, which would make your loss even larger and your gain slightly smaller, both of which would have the effect of lowering your tax bill a bit more. Hey, every bit helps.

Remember that I said you have even more flexibility when it comes to offsetting gains with losses? Well, you also can use, say, a short-term loss to offset a short-term gain; or a long-term loss to offset a short-term gain; or a short-term loss to offset a long-term gain.

The ideal pairing is long-term losses with short-term gains because when you do that you shield gains that can be taxed at ordinary income tax rates as high as 38.6 percent this year. That's even better than using losses to offset long-term gains taxable at no more than 20 percent.

But you may not always be able to arrange things so conveniently. The tax code requires that you first pair long-term losses against long-term gains, and short-term losses (losses on investments held a year or less) against short-term gains. Only after doing that can you mix short-term and long-term gains and losses.

There are two more things you ought to know before you start deducting losses. First, you can always sell an investment to take the loss and then buy it back if you believe it still has good potential for future gains. Just be sure not to violate the IRS's "wash sale" rules, which disallow all or part of your loss if you buy or sell the same security or a "substantially identical" one 30 days before or 30 days after the sale.

Second, there's a little peculiarity when it comes to mutual funds and short-term capital gains. If you sell shares of a mutual fund that you've held a year or less for a gain, that creates a short-term capital gain. And when you go through the process of offsetting short- and long-term gains with losses, you would include this short-term gain in the mix.

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But if you receive a short-term capital gains distribution from a mutual fund -- that is, a distribution resulting from the fund's realized profits in securities it has held a year or less -- you do not include this distribution in the mix. For tax purposes, a short-term capital gain from a mutual fund is considered a dividend, and it's included in your dividend and interest income for the year.

Why the government makes this distinction is beyond me. Maybe it's just another way for them to make the tax system so difficult to comprehend that we just docilely submit to it. In any case, to be sure you're following all the government's nitpicky little rules correctly, consult IRS Publication 550: Investment Income and Expenses, which lays it all out for you in excruciating detail.

Walter Updegrave is the author of "Investing for the Financially Challenged" and can be seen regularly Monday mornings at 8:40 am on CNNfn.