The Internal Revenue Code is replete with heads-you-lose, tails-you-don't-win (or don't win much) provisions. Taxable net capital gains are unlimited, for example, while only $3,000 worth of net capital losses can be deducted each year.

For mutual fund investors, the capital gains pinch is even more painful. Realized gains, typically generated when beleaguered fund managers sell off holdings to meet redemptions, must be passed through to investors, who'll owe tax even if their portfolio's net asset value plunged. Last year, when virtually all mutual funds had losses-and many had huge losses-mutual funds still made over $261 billion in capital gains distributions, according to Lipper. Shareholders paid nearly $16 billion in tax on those gains, most of which was paid by investors who reinvested their distributions rather than pocket the cash.

While mutual funds' realized gains result in tax, their realized losses result in, well, realized losses. If Fund ABC ends the year with $10 million in realized losses, it can't pass those losses through to its shareholders. Instead, realized losses carry over to as many as eight future years. "Those realized losses may offer tax benefits for investors," says Tom Roseen, senior research analyst at Lipper. "Shareholders in a fund with a capital loss carryforward may enjoy years of gains without having to pay income tax."

Assuming that securities markets will turn around eventually, positioning clients' taxable assets in funds that have carryforwards may help ease their portfolios' trip back to the black. This adds a new and potentially helpful wrinkle to the fund selection process. Carryforwards also serve to even the tax score, somewhat, between mutual funds and ETFs, which have the tax advantage when stocks have enjoyed a winning streak. Ditto, mutual funds versus separate accounts. So mutual funds are relatively more appealing than they have been.

TAX HOLIDAY

Suppose our hypothetical Fund ABC, which had a $10 million net capital loss in 2008, posts $8 million in realized capital gains in 2009. Ordinarily, that $8 million would be passed on to shareholders and taxed in 2009. However, the fund's $10 million loss carryforward would completely offset the $8 million gain-so shareholders would owe no tax for this year. In fact, the additional $2 million net loss would carry forward to 2010, to offset tax on up to $2 million of gains that year.

Carryforwards have helped power funds out of previous bears. "Many mutual funds had tax-loss carryforwards from the bear market of 2000 to 2002," says Kathy Hyatt, a principal in Vanguard's Fund Financial Services group. "Those funds did not have to make taxable capital gains distributions until those losses were all used up-around 2006 in some cases."

Even though investing in a fund with a capital-loss carryforward seems like a tax-savvy move, there are some fine points to consider. For instance, the tax benefit is meaningful only in taxable accounts. Mutual funds in an IRA don't generate income tax until money is withdrawn, so a tax-loss carryforward doesn't add tax benefits.

In taxable accounts, the tax benefits will go to the fund's shareholders, as long as they remain shareholders. But there's no tax shelter for a client who sells shares of the fund.

Suppose that Mike Adams buys Fund ABC, as illustrated above, in June 2009. Say that Fund ABC appreciates in value by 20% from the time of his purchase to year-end. If Mike holds on to his shares of Fund ABC, he may owe no tax for 2009 on that growth, as long as the tax-loss carryforward from 2008 exceeds realized gains in 2009. However, if Mike sells his Fund ABC shares to realize the gain, he'll owe tax on that 20% appreciation. Thus, loss carryforwards are most meaningful to buy-and-hold investors, especially those who reinvest distributions. The carryforwards spare long-term investors from paying tax on money they did not collect.

REALITY SHOWS

Planners who favor the idea of investing in funds with sizeable capital-loss carryforwards face an obvious obstacle-information. In addition to finding out which funds have carryforwards, advisors should try to determine the size of a fund's tax shelter.

One place to start is on Morningstar's website. By asking for a quote on a fund and then clicking on "Tax Analysis," you can see the fund's potential capital gains exposure (PCGE). That's a negative number for many funds now. "I recently ran a screen," says Don Wilson, director of portfolio management at Brightworth, a wealth management firm in Atlanta. "Out of about 2,600 funds listed by Morningstar that have at least 85% of their assets in U.S. stocks, only 25 had positive PCGEs."

The Morningstar PCGE numbers (positive or negative) include realized and unrealized capital gains or losses. The numbers come from annual reports as well as Morningstar's internal calculations from recent performance data and distributions.