Third of an eight-part series.

        Investors who jettisoned some holdings in the face of last year's stock market downturn will endure another trauma this tax season.

        Figuring the tax on capital gains and other investment income has long been one of the most tormenting aspects of filling out tax returns.

        Mercifully, the Internal Revenue Service and Congress have taken steps in recent years to ease a few of the paperwork headaches.

        And there are options available for making certain tax calculations that can minimize the tax bite on investment income.

        Many investors who received only capital gains distributions from mutual funds but have no other capital gains or losses to report can now skip Schedule D (“Capital Gains and Losses”).

        Instead, they can fill out a much shorter worksheet and report fund distributions on the front of Form 1040 or Form 1040A.

        (Being able to report the distribution on Form 1040A is new this tax season. The Form-1040 option was introduced last tax season.)

        “It's not a tax saver, but it is a time saver,” said Jim Seidel, an editor at RIA in New York, an information provider for tax professionals.

        Indeed, the shortcut option is a major simplification because the worksheet is only 15 lines long compared to 54 lines on Schedule D.

        If you're using Form 1040, be sure to read through the three-point checklist in the IRS instruction booklet to make sure you're eligible to skip Schedule D.

        If you're using Form 1040A, read the short checklist in the instructions to see if you're eligible to use the shortcut option or whether you have a type of distribution that requires you to file Form 1040.

        Everyone else with capital gains or losses to report will be stuck filling out Schedule D, including the many investors who decided to bail out of their money-losing dot-com shares to write off the losses on their 2000 tax returns.

        Capital losses can be used to offset tax on any capital gains you have, plus up to $3,000 of other income, such as salary from your job.

        Any excess losses can be carried forward to a future year.

        Schedule D looks more complicated than it actually is to fill out. The form is not intuitive. Nor is it easy to understand how the long list of calculations leads to the correct result. As a consequence, Mark Luscombe, a tax analyst at CCH Inc., a legal publisher, recommends simply following the instructions line by line. “It's one of those things where it's probably better just to blindly follow the form rather than figure out what's going on,” he said.

Computing gains tricky

        Filling out Schedule D could prove especially confusing this year for investors who decided to hedge their bets in the face of the market pullback last year and sold off only part of their holdings in a particular stock or mutual fund.

        For them, the most complicated aspect of computing capital gains will be determining the “basis” or original cost of the shares sold.

        The task is straightforward if all your shares were bought at the same time and the same price.

        But if you purchased the shares over time at different prices, determining the basis can be tricky.

        When you make a partial sale of your holdings, you're not necessarily free to pick which shares to report as having been sold on your tax return. Only those who instructed their broker or mutual fund at the time of the sale which specific shares to sell are allowed to designate on their tax return those particular shares as the ones that were sold. This is known as the “specific-identification” method.

        It usually pays to provide such specific instructions when you're selling part of your holdings because you can designate those shares that will result in the smallest taxable gain possible.

        If you merely told your broker or fund manager to sell a certain number of shares, but not which specific shares, the IRS has a “first-in, first-out” (FIFO) rule for identifying which shares were deemed sold. The big problem with the FIFO rule is that if your shares have steadily risen in value, the FIFO method will usually result in the biggest taxable gain possible because the shares presumed sold would have been those acquired at the lowest price.

        Fortunately, most mutual-fund investors are eligible to take advantage of an alternative method, known as “average cost.”

        This option allows you to base your gains on the average cost of all shares in your account. Averaging isn't as beneficial as the specific-identification method. But if your fund shares have steadily risen in value, the averaging method will produce a smaller taxable gain than the FIFO method.

        Be aware that once you take advantage of the average-cost method, you must continue using it for other sales of shares in that fund.

        The averaging method has proven to be a salvation during the long bull market of recent years when most shares have risen steadily in value.

        But with last year's market downturn, averaging may not be the best option for investors who bought at high prices and then sold shares after the market tanked, said Bruce Wertheim, a senior manager at the accounting firm of KPMG in New York.

        The option to use averaging is available for only mutual fund shares. Investors who sold shares of an individual stock are stuck with the FIFO formula unless the shares qualify for the specific-identification method.

        Gary Klott is the editor of TaxPlanet.com, a year-round tax information Web site, and a nationally syndicated tax columnist.

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