With three months left in the year, now is a good time for investors to swap bonds to enhance their investment position. A bond swap occurs when an investor sells a bond at a loss and replaces it with a similar bond. Investors swap bonds for many reasons but the main reason is to avoid taxes. Municipal bonds are most often used in swap transactions, although investors also will use taxable bonds such as corporates and treasuries.

When dealing with the tax advantages of bond swaps, certain guidelines must be adhered to. First, a long-term or short-term loss depends on the length of ownership. The Tax Reform Act of 1984 states that an investor must hold a bond for more than six months to establish a long-term capital loss (or gain). Any bond held less than six-months creates a short-term capital loss (or gain).

The holding period for a bond begins the day after the trade date and ends on the execution date of the sale order. For purposes of computing a gain or loss, a gain is established on the settlement date, while a loss is established on the actual trade date of sale. Bond swaps may be conducted at any time during the year. Swaps for losses may be executed as late as the last business day of the year to offset the year's taxes.

Investors may use long-term capital losses to offset long-term capital gains dollar-for-dollar. They also may use the capital losses as a deduction against ordinary income, but only up to $3,000. However, it takes $2 of long-term losses to offset $1 of ordinary income. Thus, to reach the $3,000 limit, an investor would have to lose $6,000.

On the other hand, investors may use short-term losses on a dollar-for-dollar basis to offset ordinary income, but only up to $3,000. Losses in excess of $3000 may be carried over into the next year or until the losses are exhausted.

In doing tax swaps, at least two key features of the bond must be changed in the new security. The new bond must have a different coupon, maturity or issuer. If an investor likes a particular bond, he may sell it for a loss and buy back the same bond, but only after 30 days have passed. If a substantially similar security has been purchased within 30 days before or after the date of the sale, the Internal Revenue Service could disallow the loss as a wash sale.

Peter Gordon, the President of T. Rowe Price's tax-exempt bond funds, offers some sound advice concerning tax swaps. Gordon believes that all things being equal, an investor's total return on investment should dictate where the proceeds of a tax loss sale should be invested. Total return reflects both the income and price appreciation (or depreciation) of an investment.

In other words, Gordon believes the investor "should not be close-minded to the math and mechanics of a bond swap, but the investor should re-evaluate the total spectrum of investment opportunities. A loss can be taken anytime. Why not place the proceeds in an investment that you feel will outperform the one you are selling."

The proceeds could be invested in a shorter, similar or even longer bond, or in equities or real estate, whichever offers the most promising outlook. In this manner, an investor breaks the chain of constantly selling a bond, taking a loss, extending maturity while waiting for the next loss. A total return approach makes sense.