NEW YORK (Money Magazine) - If you're like most investors this year, you're sitting on a pile of losses. But those losses have an upside: By using them well for tax purposes, you can turn them into real cash -- and put yourself in a better position for the future.

What could those losses be worth to you personally? Potentially, thousands of dollars. Take a simple example: If you book a long-term capital gain of $10,000 this year without an offsetting capital loss, you'll owe the IRS $2,000, even if you have thousands of dollars of paper losses.

If you take an equivalent $10,000 capital loss (preferably also long term), you'll owe no capital-gains tax. And if you take $13,000, you can book a $3,000 net capital loss to write off against regular income. In the 30 percent tax bracket you'd be $2,900 better off. The larger your gains and losses, the more these basic and perfectly legitimate moves will be worth to you.

The goal is to avoid the position many found themselves in during the bull market. "A lot of people took money off the table and wound up paying a lot of capital-gains taxes," says Martin Nissenbaum, national director of personal income tax planning at Ernst & Young. "Yet when they added up their realized gains and unrealized losses, they had made nothing in the market." Since capital losses cannot be carried backward, they were simply out the money, a result that, as Nissenbaum puts it, is "a real kick in the pants."

While the dollars at stake in a bull market may be larger, in today's bear market savvy tax planning will not only save you money but also allow you to build a better portfolio and have the IRS foot the bill. Here's our seven-step strategy for making the most of your losses now and for years to come.

Begin by clarifying your investing goals. What kind of investor are you? What is your time horizon? How much risk are you willing to take? Then consider how your tax strategy can help you achieve your objectives.

Your losses may, paradoxically, give you the flexibility to rebalance or improve the quality of your portfolio for free. If you're like most of us, the bear market for stocks and bull market for bonds have put your asset allocation out of whack.

"If there are substantial capital losses in your portfolio, you can take some gains that are easily offset by losses and use the cash generated to rebalance your portfolio without any tax consequences," says Joel Dickson, the tax expert at Vanguard. "In a rising market you incur taxes; in this situation you do not."

You may also be able to create a better portfolio by swapping a mediocre or high-cost fund for a better one or by unloading a stock you no longer want for one that you do -- again with no tax hit. You could, for example, sell your Vanguard 500 Index fund and put the proceeds in Vanguard Total Stock Market Index fund to get broader market exposure.

If your goal is to rebalance or improve your portfolio, sell your entire position and put all the money into the new one. Not only does this make the most sense from an investing standpoint, it also lets you avoid some nasty tax arithmetic.

On the other hand, if you need cash for some worthwhile goal -- to buy a house, say -- if you want to book a specific-size loss to offset a gain booked earlier this year, or if you want to reduce your stake in a fund that's closed to new investors without being shut out of it, then unloading a portion of one holding may make sense. That may involve some excruciating math, discussed below.

Whatever your strategy, start now. Don't wait for the year-end statements that brokerages and mutual fund firms send out in early 2003. If you do, you'll lose flexibility to match capital gains and losses in the best way for this tax year.

To get the most out of your losses, you'll need to understand how the tax rules work. "The only thing worse than losing is losing and not being able to mitigate the loss with a tax write-off," says Gary Schatsky, a New York-based financial planner.

The IRS allows you to offset gains with losses, first matching short-term gains (on investments held for a year or less) with short-term losses, and long-term gains (more than a year) with long-term losses; only then do you determine what the net effect of your losses and gains will be.

Because long-term gains are taxed at the capital-gains rate of 20 percent and short-term gains at regular income tax rates, "short-term losses are more valuable," says John Battaglia of Deloitte and Touche's private-client group.

The end result (reported on Schedule D) is simple: For every $1 in losses you take, you can cash out $1 in gains without owing any tax. So if you sell your long-term holdings in Procter & Gamble for a $10,000 gain, you should sell something for a $10,000 loss.

After matching your gains with your losses, take $3,000 in net capital losses against your income -- and do it every year. In the 30 percent tax bracket, this alone cuts your tax by $900.

What if you've got more than $3,000 in losses that you cannot match against gains? You can still take them, but you'll have to save them for the future.

In tax lingo, you'll get what's termed a net capital loss carryover. You can use it to offset future capital gains and lower income by $3,000 a year until it runs out. "Generally, you are better off having the loss there and available to you, rather than having it built into some asset you are holding," says Kaye Thomas, a tax attorney and author of Capital Gains, Minimal Taxes.

Note: If you build such a large stockpile that you can never use it up, your capital-loss carryover will die with you. But you'll do your heirs no harm. Your paper losses will die too, since there is a step-up or step-down in the cost basis of your investments upon your death (with the possible exception of that tricky year, 2010).

Here's where things get complicated. The IRS allows taxpayers a number of different methods for calculating the cost basis of their investments; the various options can result in wildly divergent tax bills in any one year.

For individual stocks, there are two methods: first-in, first-out, or FIFO, in which the shares acquired earliest are assumed to have been sold first; and specific-share identification, in which you choose your own tax lot. For funds there are two additional methods: a simple average and a double-category average, with separate short-term and long-term calculations.

According to IRS regulations, the default method for both stocks and funds, unless you specify otherwise, is FIFO. Perhaps not surprisingly, this often leads to the worst possible tax result. In a rising market, it yields the largest gains and thus the highest current tax. In a declining market, it may give the largest capital losses -- just when they are of least use. It could even result in your owing taxes on a sale despite having an overall loss in that security.

If you are selling individual stocks, it's no more difficult to do specific-share ID than FIFO. Just identify the shares you are selling to your broker at the time of the transaction, and receive written confirmation. If you previously used FIFO, you can switch simply by saying so on your tax return.

Whichever method you use, remember to add any expenses incurred on the purchase, such as commissions or mutual fund loads, and to deduct transaction costs from the proceeds when you sell. While most brokers will report the net figure on Form 1099, they are not required to do so.

For funds, everything's a little more complicated. Most fund companies, including giants Fidelity, Vanguard and T. Rowe Price, send shareholders annual statements with the cost basis calculated as a simple average. If you liquidate your entire position in a fund, simply copy that number onto your Schedule D and tell the IRS that's the method you chose.

But if you want to pare back, rather than sell off, your holdings in a fund, selecting the shares you want to sell gives you more flexibility to match capital gains with losses. "Specific-share identification would always give you a better result, but it could make you crazy," says Ernst & Young's Nissenbaum.

Some financial advisers argue that it's not worth the hassle for a potentially small tax saving. For many investors, they may be right. But if your position is large, or you want a specific amount of cash, specific-share ID may be right for you. We think that even small tax savings can add up in a meaningful way -- every little bit helps in this market. As a general rule, the more variation in the prices you paid over time, the greater the difference it will make on your taxes.

If you want to use specific-share ID for taxes, you'll need to identify those shares at the time of the sale and get written confirmation. How easy this will be depends on your investment pattern and your own record keeping. If you've put money into a fund only a few times, and have good records, it shouldn't be too hard.

On the other hand, if you've been dollar-cost averaging into a fund for many years, the calculations can get messy. Fidelity has rolled out an online program that helps investors identify the best tax lots to sell and automatically calculates the tax information. Other fund companies will provide historical data on your transactions, but you will need to figure out which shares best serve your purpose.

One warning: If you previously used the average method, you'll likely have to stick with it for that fund. Though some fund companies tell investors, correctly, that you can petition the IRS for a change of accounting method, tax experts say they've never seen anyone do it. And there's a $1,200 fee.

Mark Luscombe, federal tax analyst at tax publisher CCH, argues that the IRS would be unlikely to grant such a request if its sole purpose were to lower your taxes. If you believe you must make the switch from average to specific, you'd be better off liquidating your entire position and reinvesting it, remembering to wait long enough to avoid triggering the wash-sale rule if you have a capital loss.

A final note: Dividends complicate matters, especially for funds. When you receive your dividends as shares, it's as if you bought new shares (at a new cost basis) on that date. If you've been averaging, this number gets thrown into the pot with your other fund purchases. If you're using specific-share ID, each dividend reinvestment creates a new tax lot.

Caveat emptor. This is the part of taking capital losses that trips up more investors than anything else. The wash-sale rule is the IRS regulation that prohibits you from taking a loss on an investment if you buy new shares within a period that begins 30 days before the date of the sale and ends 30 days after -- a total of 61 days.

If you want to take a loss on your shares of AMR, parent of American Airlines, down 77 percent this year, for example, you cannot buy AMR shares for 30 days before or 30 days after you sell. If you want to keep your exposure to the troubled airline industry, you could sell your AMR at a loss and use the proceeds to buy, say, Delta Air Lines, down 63 percent. Or you could double up on AMR, wait 31 days and then unload your old shares for a loss.

The same rule applies to funds, with a caveat: Selling one fund firm's S&P 500 index fund and buying one from another fund family would likely trigger the wash-sale rule. While the IRS has not formally ruled on this, we wouldn't want to be the test case. You could, however, sell Fidelity Magellan fund for a loss and buy Fidelity fund -- even though eight of the funds' top 10 holdings overlap.

Investors make the most mistakes with the wash-sale rule when they trigger it unconsciously -- often with purchases made passively on their behalf. "It is easy to fall under the wash-sale rule by accident," says Michael Beriss, a Baltimore-based financial adviser.

A dividend reinvestment, an automatic monthly investment in a mutual fund or a transaction in an employee stock-purchase plan all might accidentally trigger the wash-sale rule. If this could happen to you, you have two options. You could turn off your dividend-reinvestment and automatic-purchase programs before the blackout period and restart them afterward. Or you could leave everything in place and deal with the wash-sale fallout.

While the former is easier for tax purposes, it does interrupt your dollar-cost-averaging strategy. And if you turn off those passive investments, you'll be faced with a real decision about what to do with the cash that's not being invested.

Many investors fear the wash-sale rule, and triggering it does create some complications. But even if you do fall afoul of it, you won't completely lose out on the benefits of the capital loss. They will just be pushed off to a later date, and you'll face some nasty mathematical calculations.

How does the math work? In true IRS fashion, of course. You won't actually report the transaction as a capital loss. Instead, the disallowed loss is added back into the cost basis of the stock you purchased that triggered the wash-sale rule. (The holding period of that stock is also adjusted, prohibiting you from converting a long-term loss into a short-term one.)

Let's say you bought 100 shares of Intel in 1999 for $42 a share, or $4,200, a nd recently, with the stock at $18, you decided to sell and take the loss. You would book a long-term loss of $24 per share, or a total of $2,400.

But what if Intel reports some good news, the stock goes to $20 and you decide to buy back those 100 shares before the blackout period is up? Here's how your taxes would work: You'd be prohibited from claiming the loss this year, but that $24-a-share disallowed loss would be added into the new stock's basis, bringing it to $44 a share. If you later sell at $20, without triggering the wash-sale rule, you'd then report a loss of $24 per share, or $2,400. "You end up with this crazy basis, where you think your basis is one thing but it's not," says Tom Ochsenschlager, a partner in the federal tax practice of Grant Thornton. "The mathematics will get you upside down."

In fact, the math for the most common wash-sale violation is even slipperier: The loss that is disallowed is proportional to your purchase during the blackout period. So if, in the above example, you bought back only 10 shares of Intel through an automatic-purchase plan, you would be allowed to write off $2,160 of your loss this year; the remainder would become an adjustment to the cost basis of your new shares.

What if you own shares of a defunct company? Or one in bankruptcy? According to the IRS, if an investment becomes worthless, you may write it off. However, you must do so in the year in which it became worthless or you lose the ability to write it off at all. For taxes, the worthless investment is treated as if it were sold on the last day of the year.

But beware. Deciding what's worthless in the eyes of the IRS is like parsing the meaning of the word "is."

If the stock still trades, it's not worthless, even if its value has been eviscerated. A Chapter 11 bankruptcy filing does not automatically make a stock worthless, but a declaration from bankruptcy court that shareholders will get nothing under a reorganization plan probably does. A Chapter 7 bankruptcy, on the other hand, likely does make those shares worthless.

If you have shares of bankrupt telecom WorldCom, for example, they still trade in the pink sheets for a recent 10 a share. Global Crossing, too, still changes hands, though at less than 2 a share. Thus neither of these clunkers is, on the face of it, worthless for tax purposes. "The IRS seems to take a hard position on this," explains CCH analyst Luscombe.

There is one out: if you try to get your broker to sell those shares and he or she cannot. This leads to our simple rule for navigating the IRS' definition of worthless: If you think your shares have no value, tell your broker to sell them. If you can't find a buyer, you may be able to have them declared worthless. Get a letter from your broker for documentation (in case you are audited), and when you file your taxes, enter "worthless" on your Schedule D to describe the loss.

If it turns out -- surprise, surprise -- that you can sell your holding, just take the minuscule proceeds and account for the transaction as a regular capital loss on your taxes this year. Then you won't have to worry about missing the year in which it technically becomes worthless. (You may be able to get around this by filing amended tax returns for the year in which the investment did become worthless, but why set yourself up for that irritation?) Either way, you will have cleared your portfolio of a loser and gotten a capital loss for tax purposes.

The only reason to hold on to an investment that appears to be worthless is if you strongly believe that the company will recover. But don't count on it. In a bankruptcy filing, creditors get paid first, and it's rare that much, if anything, is left over for the holders of common stock.

We know that tax planning can make your head hurt. The only thing we can tell you is, take an aspirin and hunker down. You'll want to make sure that you not only get this year's taxes right but that you also set yourself up well for next year and beyond. That means planning early -- and starting to take losses before you're up against the deadline. "Loss harvesting on an aggressive basis throughout the year makes sense," says tax attorney Thomas.

There's one additional complexity to keep in mind: the 18 percent extra-long-term capital-gains rate. Come 2006, it will be valid for any stock or fund that you've held for more than five years. Keep your records in order so that you'll be able to take advantage of it when it kicks in. And be warned -- that will create yet another way to figure your cost basis: triple-category averaging.

Tax planning is no substitute for a broader investment strategy, but understanding the tax implications of each move you make in your portfolio can be very valuable. As the last few years have reminded us, market returns are neither predictable nor controllable. As arcane and complex as the tax code is, this is one area of your portfolio that you can control. Realizing your losses will mean a higher after-tax return, giving you more real money to live the way that you want. And that, after all, is what investing well is all about.