What it is:
How it works (Example):
John wants to deduct this loss on his tax return, but he can only do so if he actually sells the shares. John believes that the sector in which Mutual Fund XYZ invests is a good long-term investment, so he does a tax swap: He sells his 1,000 shares of Mutual Fund XYZ and uses the money to purchase shares of Mutual Fund ABC, which invests in the same sector and uses many of the same trading methods. This enables John to deduct the capital loss on his tax return while staying invested in virtually (but not exactly) the same investment.
Why it Matters:
Although investment losses are generally tax deductible, selling securities at a loss in order to get a tax benefit and then buying the stock back right away is prohibited by the IRS. The IRS prohibits taxpayers from deducting losses on the sale of an investment if the taxpayer purchases the same security 30 days before or after the sale (called a "wash sale"). Wash sales are prohibited, tax swaps are not.